The Australian Taxation Office (ATO) is about to write to approximately 17,700 SMSFs to highlight their concerns that the fund may hold more than 90% or more of its assets in one asset, or a single asset class.  From this evidence, the letter from the Regulator raises the issue that the fund may be at risk of not meeting the diversification requirements within the fund’s investment strategy that must comply with the operating standard in SIS Regulation 4.09.

It is expected that in the majority of cases these letters will focus on funds with property-based investments.  Whilst not directly linked, it appears that this follows on from the work that the ATO has completed in conjunction with the Council of Financial Regulators (CFR) into the ongoing review and future viability of LRBAs.

It is important to note that trustees do have a right to invest within a single asset class should they choose to do so.  However, what the ATO is looking to do here is to ensure that the investment strategy adequately considers the decision made by the trustee(s) in concluding to invest within a single asset class (or has high asset concentration).  This includes the trustee(s) having assessed and being aware of the risks associated with an undiversified investment portfolio.

 

Poorly developed investment strategies

Too often I see SMSF investment strategy documents supposedly built by trustees that aren’t worth the piece of paper their written on.  A single page document, the investment strategy reflects what the operating standard says, having considered risk and return, liquidity, diversification, cash flow and insurance cover for one or more members.  Some documents may extend this further providing asset allocation ranges of 0 – 100% to ensure that they don’t breach the SIS requirements with their fund auditor – this requires an SMSF auditor to have sighted a documented investment strategy and ensuring that they are acting in accordance with it.

I’ve long been a critic of this approach within the SMSF sector where the role of the investment strategy has been as a compliance document, rather than a tool to help develop and meet retirement outcomes.  This appears to be a by-product of accountants being scared of the role they can play in helping trustees in this area of the investment strategy, concerned that they may breach any licensing limitations.  This is part of the reason why in my previous blog post, ‘could accountants being heading back to the future’, I spoke about the importance of needing to re-calibrate the role of an accountant as a service provider in the SMSF industry.

So, where do we as an industry head with this renewed level of guidance from the ATO?

 

Quality of SMSF advice

In June 2018, we saw ASIC release Report 575: SMSFs – improving quality of advice and member experiences (REP 575) following a large research project to examine:

• member experiences in setting up and running a self-managed superannuation fund (SMSF) (member research); and
• whether advice providers are complying with the law when providing personal advice to retail clients to set up an SMSF (advice review).

From this research, ASIC provided some practical tips that advice providers can use to improve the quality of SMSF advice they provide to SMSF clients, which included areas of high asset concentration as part of the fund’s investment strategy.

 

What can we learn from REP 575 for a fund’s investment strategy?

REP 575 provides some important insights into the expectations and considerations in the development of a fund’s investment strategy, in particular where the fund invests within a single asset class or where heavy asset concentration exists.

The table below is how I see that ASIC’s guidance in REP 575 can be applied into trustee decisions with the investment strategy, in particular with a single asset class or heavy asset concentration:

 

REP 575	Trustee Considerations
Ensure that the Statement of Advice (SOA) adequately documents the basis in light of the client’s financial situation, needs and objectives.	Ensure that the trustees in formulating the fund’s investment strategy have considered the needs and objectives of the fund members.
Why investing in a single asset class is appropriate (rather than a diversified portfolio)	Why investing in a single asset class (or to be have heavy asset concentration) is considered appropriate in the circumstances, rather than a diversified portfolio.
Whether the investment will generate a sufficient return for the client’s retirement needs (and if not, what the exit strategy is and any costs or risks associated with this exit strategy)	Whether the investment will generate a sufficient return to meet the fund objectives set by trustees (e.g. specific objective of obtaining a target rate of return).  In circumstances where not met, what steps the trustees will take to exit such an investment, along with the costs and risks associated in exiting to ensure that the trustees can meet the fund objectives.
Explain how investment strategy is likely to change as members approach retirement and their needs and circumstances change.	Explain based upon the age profile of the members how the fund will change over time (including through diversification) to meet the needs of the members as they approach retirement (e.g. liquidity and cashflow).
If property is the preference, consider whether property is appropriate.	Explain through the investment strategy as to why investing into property as a single asset class or where high asset concentration is an appropriate outcome to meet the fund’s objectives.  Also, how the trustee will devise a plan to reduce risk over time (e.g. through future contributions and fund earnings).

 

Where the SMSF is investing in property, REP 575 outlines the following advice requirements in advising SMSF clients:

• The needs and circumstances of the fund’s members (age & retirement needs);
• If the recommendation involves an investment loan (LRBA), how long it will take for the client to repay the loan?
• The high upfront costs of purchasing property (e.g. stamp duty, loan fees, estate agent fees);
• The fund’s ability to repay the loan if an unexpected event occurs (e.g. client becomes unemployed for a period of time);
• How the client’s retirement will be funded by the property investment (i.e. through sale of property or through rental income);
• How likely it is that the property can be sold quickly (i.e. whether it’s in a high demand area); and
• What the client will do if the property is not rented for a period of time?

All of these areas can be easily transferable into actions or requirements that trustees should be addressing as part of formulating their fund’s investment strategy.

 

Role of fund auditor

The ATO is also advising within this letter that they will be writing to the auditor of these funds to notify them of their concerns.

It will be up to the auditor to identify and determine whether the fund has failed to comply with the requirements outlined within SIR 4.09 which could result in administrative penalties applying of $4,200 (20 penalty units).

It is expected that the ATO will provide further guidance in respect to this topic to assist both trustees, auditors and other SMSF professionals to better understand and meet these investment strategy requirements within the SIS Regulations.

 

Need an SMSF investment strategy?

Smarter SMSF provides a comprehensive SMSF investment strategy which formulates and gives effect to risk, diversification, liquidity, the ability to discharge the fund’s liabilities and the requirement to consider insurance cover for one or more fund members.

Find out more about the SMSF Investment Strategy document.