• If your SMSF is invested in mostly one class of asset, you must rethink your investment strategies.
• Consider the risk, fund composition, liquidity, liability and insurance for the investment members.
• SMSFs held by families need to consider relationship break down and deaths.
• Read on to learn the five important components you need to consider in your investment strategy

In August 2019, the Australian Taxation Office (ATO) started writing to some 17,700 self-managed superannuation fund (SMSF) trustees and their auditors about their fund’s investment strategy. The tax office campaign is focused on SMSFs that are significantly invested in a single asset or class of assets.

The reason? Diversification, or rather, the lack of diversification.

Why you need an SMSF investment strategy 

With this ATO compliance campaign in full swing, now is the right time to consider your investment strategy. When I first saw the tax office’s announcement on this campaign, front of mind were those funds that I have chosen to invest in property with only a small amount of cash held in the bank account.

Indeed, the ATO has since stated that the campaign was implemented due to concerns held around spruiker activity and inappropriate advice involving residential property and limited recourse borrowings.

However, it is not just those invested in property that should be addressing the lack of diversification in their investment portfolio.

SMSF auditors will be paying greater attention to any fund where a single investment represents a significant value of the fund. This covers a broad range of investments including, for example, gold bullion or even a single substantial investment in a single company in the form of listed or unlisted shares.

It should be pointed out, however, that the law does not prohibit a SMSF from investing in a single asset or having a low level of diversification. The tax office with its regulator hat on is concerned that some trustees have not adequately considered and addressed the risk of low or no diversification in their SMSF investment strategy.

With little or no diversification, you are effectively putting all your eggs into one basket. With that inherently comes increased risk.

The need for an investment strategy is not a tax office protocol. The superannuation law requires all SMSF trustees to formulate and regularly review their investment strategy. The legislation and associated regulations require trustees document and to consider several factors in the investment strategy.

Broadly, this includes risk, returns, liquidity, cash flow, investment composition, and diversification including the risks from a lack of diversification.

Trustees are also required to consider whether to hold a contract of insurance for members and to note this in the investment strategy.

What to consider in your SMSF investment strategies?

Let’s examine those components in a little more detail.

1. Risk  

The risk involved in making, holding and realising, and the likely return from the SMSF’s investments, having regard to its objectives and expected cash flow requirements.

2. Composition

The composition of the SMSF’s total investments, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification.

What we are talking about here are the types of investments the SMSF is invested in and to what extent it is invested in those assets. Different classes of investments include cash, fixed interest deposits, Australian listed shares and managed funds, property, international shares, etc.

The concept of diversification is an important consideration for both addressing risk and the composition of fund investments. Diversification is the spread of investments across different asset classes or types of investments.

By spreading your investments in this manner, it helps to manage your risk and the volatility of your investment portfolio. The theory is that if one investment does not perform well, it is only a small part of your portfolio. This loss will be offset by other investments within the portfolio that are performing well.

Low levels of diversification increase your risk. If a single large investment stops generating income, there are no other sources of income for the fund to fall back on. This can start to create liquidity problems for the fund.

However, investment strategies that select every available investment class and include an investment range of 0% to 100% for each, is not adequately addressing the SMSF’s composition and diversification of its investments.  Specifically, you should document how your fund is going to be invested and address why it is invested in that manner.

3. Liquidity 

The liquidity of the SMSF’s investments, having regard to its expected cash flow requirements.

How easily can fund investments be converted to cash? What income will the investments generate? How does the fund address its liquidity if a single large investment is not income producing but held for its future capital growth opportunities? What are the expected contributions to the fund? What is the impact to the fund if contributions cease?

4. Liabilities

The ability of the SMSF to discharge its existing and prospective liabilities.

Whilst this includes the ongoing expenses and tax liability of the fund, it also extends to the payment of benefits to pension members or on the death of a member.

If your SMSF has used a limited recourse borrowing arrangement to purchase a property, the fact that there is a borrowing also increases the risk to the fund. As trustees, you need to consider and address in your investment strategy how the fund will meet its loan obligations. Will the fund have enough cash flow to meet its obligations?

What if a member ceases work, and contributions are no longer received by the fund? Or the property ceases to receive rental or leasing income? How will the SMSF meet this liability?

These are important steps that are often overlooked or not adequately addressed by SMSF trustees.

5. Insurance

Whether the trustees of the fund should hold a contribution of insurance that provides insurance cover for one or more members of the fund.

It is not compulsory that the fund provides insurance for members (e.g. life, TPD). However, it is important that trustees have considered insurance and document the reasons why insurance cover is provided or why not.

This was introduced as an integrity measure as there were concerns by regulators that many people moving to a SMSF did not adequately address the need for insurance. Once all your superannuation benefits are rolled into the SMSF, any insurance cover that was included in the former fund will be lost.

As each SMSF is unique, an investment strategy that addresses the specific needs of the members should be documented. My SMSF investment strategy won’t work for you.

Likewise, it is not a standard minute that you sign off automatically each year with your accounts. A cookie cutter approach should not be taken with your SMSF investment strategy.

An investment strategy is a prospective document. It sets the trustees intentions on how the fund is to be invested.

It is a document you should be reviewing at least annually, and every time you make any new investment decisions. You need to also think about the changing needs of the members, such as when they are approaching retirement or commencing a pension.

An investment strategy is not only an essential compliance document, it is also a helpful tool for trustees too.

A good investment strategy with a regular review process aids in the monitoring of your funds’ performance with questions such as:

• Do the investments align with your accepted level of risk, long term goals and objectives?
• How liquid is your fund? Trustees need to ensure that the SMSF holds enough cash to pay pensions, fund expenses and liabilities - this year and into the future.
• Will the income from investments provide enough cash flow? How quickly can fund investments be converted to cash?

Apart from the compliance requirement prescribed by superannuation law, investment strategies also provide protection for SMSF trustees.

A good investment strategy will not guarantee the returns a fund will receive from its investments. Investing involves risk and not all investments perform how we think that they will. The fact that the SMSF suffers a loss from an investment doesn’t necessarily mean that the investment strategy has failed.

What happens when an SMSF fund is held by a couple?

An investment strategy can offer a level of protection to trustees in the event of a dispute or litigation from a beneficiary who suffers a loss. More importantly, there needs to be a properly documented, compliant investment strategy that has considered the risks of the fund’s investments and needs of members.

SMSFs can have up to 4 members, but around 70% of the SMSF population have two members. The majority of these will be couples. Therefore, if spouses are running an SMSF together, what is the risk of litigation?

The sad reality is that relationships break down. Following a separation, I have seen disputes arise that need to be resolved during the Family Law process. It can also lead to separate legal matters being commenced to address issues in the fund.

The other problem with SMSFs is you need to consider all beneficiaries including potential beneficiaries. When we think of beneficiaries to superannuation, we immediately cast our minds to the members of the fund. After all, the superannuation account has been contributed to and invested for the purpose of providing retirement benefits for that member.

What happens if that member dies? Who now become the beneficiaries? Often it is the surviving spouse, but it can also include children. Further complications arise from second marriages and relationships where the beneficiaries are not the children of the surviving spouse. Sadly, this can be a hot bed for dispute, particularly, if losses have been incurred by the fund.

This tax office campaign is an important reminder for all SMSF trustees to give their fund a health check and carefully review and, if required, update their investment strategy. If you are one of the trustees that the ATO has contacted, don’t panic. 

They are giving you the opportunity to seek advice and make sure your investment strategy meets the requirements. Importantly, make sure you do so now and provide your updated strategy to your SMSF auditor who will be looking a little more closely this year to make sure your SMSF complies. 

Whilst the tax office is engaging with trustees now, penalties will apply if you fail to comply.