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Consequences of underpaying your SMSF pensions

Are Your SMSF Eggs in One Basket? Avoid Risks, Diversify

The Australian Taxation Office (ATO) has raised concerns about the lack of diversification in some Self-Managed Superannuation Funds (SMSFs), citing the potential risks associated with concentrated investments. According to the ATO, “a lack of diversification or concentration risk can expose the fund and its members to unnecessary risk if a significant investment fails.”

Do SMSFs Require Diversification?

While the ATO highlights the risks of poor diversification, there is no legal requirement that funds must diversify their investments. Trustees can strategically choose a concentrated investment approach. However, it is critical for trustees to demonstrate that this strategy was an informed and deliberate decision.

The Superannuation Industry (Supervision) Regulations (SISR) Section 4.09 mandates that trustees must:

  • Formulate, review, and implement an investment strategy that considers the entirety of the SMSF’s circumstances.
  • Regularly assess the strategy to ensure it aligns with the fund’s objectives and compliance requirements.

Key Steps for SMSF Trustees

To comply with the SISR and satisfy the ATO’s concerns, trustees should:

  1. Recognise Investment Risks: Identify the risks associated with your investment choices, evaluate their potential impact on the fund, and ensure they align with the SMSF’s objectives and cash flow needs.
  2. Review Diversity or Concentration Risks: Assess the fund’s exposure to risk due to a lack of diversification and determine whether the strategy aligns with the SMSF’s long-term goals.
  3. Evaluate Liquidity and Cash Flow Needs: Examine the liquidity of investments and ensure the fund can meet its cash flow requirements, such as paying member benefits when required.
  4. Ensure the Fund Can Meet Liabilities: Verify that the fund has sufficient assets to discharge its liabilities and obligations without undue stress.
  5. Review Insurance Coverage: Assess and maintain appropriate insurance cover for members and the fund’s assets to mitigate unforeseen risks.

The ATO’s Targeted SMSF Review

The ATO has identified 17,700 SMSFs with 90% or more of their assets concentrated in a single investment or asset class. These funds are under scrutiny to ensure their investment strategies are sound and deliberate.

One area of particular concern is property investment. Many SMSFs have significant exposure to property, and with fluctuating property prices, the asset value of these funds can be volatile.

Limited Recourse Borrowing Arrangements (LRBAs) and SMSFs

The use of Limited Recourse Borrowing Arrangements (LRBAs) to purchase property has grown significantly. Between 2013 and 2017, the number of funds utilizing LRBAs increased from 13,929 (2.9% of SMSFs) to 42,102 (8.9% of SMSFs).

For funds using LRBAs, these borrowings often represent a substantial portion of total assets. On average, LRBAs account for 68% of the assets in such funds. These arrangements are most common in funds with net asset sizes between $200,000 and $500,000. In 2017, the average borrowing under an LRBA was $380,000, with an average total asset value of $768,600.

Am I Wealthy Enough for an SMSF

The Risks of Concentrated Investment in Property

The ATO’s concern extends to funds heavily invested in property due to the potential for:

  • Volatility in property prices: A downturn in the market can erode the value of the fund significantly.
  • Debt-related risks: With a large portion of assets tied up in property and associated borrowings, any negative shift in the market can severely impact the fund’s financial health.

Justifying Your Investment Strategy

Trustees must be prepared to justify their investment decisions, particularly if their fund holds concentrated assets. This means maintaining robust documentation that demonstrates:

  • The rationale behind the investment strategy.
  • Regular reviews of the strategy in light of changing market conditions.
  • Evidence that all decisions align with the fund’s goals and obligations under the law.

Diversification is not legally mandated for SMSFs, but it plays a critical role in mitigating risks and ensuring the fund’s financial stability. Trustees who choose a concentrated investment approach must take active steps to demonstrate that their strategy is deliberate, well-considered, and compliant with regulations.

By addressing these concerns and adhering to best practices, trustees can safeguard their funds from unnecessary risks while achieving their long-term financial objectives.

Read this great article from The West Australian.

Learn more about buying property in your SMSF here.

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