02/05/2011

Investments of self managed superannuation funds ("SMSFs") are dictated by the investment strategy.  A properly formulated investment strategy is one of the core requirements of the Superannuation Industry (Supervision) Act 1993 ("the SIS Act").

The importance of a properly formulated investment strategy is reinforced by a provision in Regulation 4.09 of the SIS Regulations which designates the investment strategy covenant to be an operating standard under the SIS Act.  Breach of an operating standard is a serious offence which may result in civil penalties, loss of fund compliance status and the trustee may be disqualified, removed or even prosecuted under the Criminal Code.

So what are the investment strategy requirements and how does a fund comply with them when it wants to invest using a limited recourse borrowing arrangement?

The investment strategy requirements

1.    Section 52(2)(f) of the SIS Act makes provision for the investment strategy.  The covenant is deemed to be included in the governing rules of the fund.  The trustee must formulate and give effect to an investment strategy of the fund having regard to the whole of the circumstances including but not limited to:

• The risk involved in making, holding and realising and the likely return from the investments having regard to objectives and cash flow requirements;
• The composition of the investments as a whole including the extent to which the investments are diverse or involve the fund in being exposed to the risks from inadequate diversification;
• The liquidity of investments having regard to its expected cash flow requirements;
• The ability of the fund to discharge existing and prospective liabilities.

The Regulators recognise that compliance with the investment strategy will not guarantee the fund’s investment performance.  However, an investment strategy formulated in accordance with the relevant requirements may potentially reduce the downside risks, enabling the fund to discharge its liabilities and meet benefit payments when they fall due.

2.    The trustee is also required to monitor, implement and give effect to the investment strategy, and to modify the strategy in response to changing circumstances and investment conditions.

The investment strategy format

1.    The investment strategy should be signed by the trustee(s) of the fund and adopted in a meeting of the trustee(s) or by trustee written resolutions if permitted by the governing rules of the fund.

2.    Alternatively, the investment strategy can be formulated in a meeting of the trustee(s) or by trustee written resolutions.

The ATO perspecitve

The ATO considers that the investment strategy should set out the trustee considerations in the formulation of the strategy and how the strategy or investment methods will achieve its stated objectives.  A well formulated investment strategy should provide reasons and the considerations for the strategy.

Single investment funds

The Regulators are of the view that a well formulated investment strategy does not ordinarily provide that all the funds will be invested in one asset or a single asset class.  In relation to business real property, the ATO has stated in its publication "Running a Self Managed Super Fund" that "a fund with 100% investment of assets in business real property could have some problems in meeting these requirements (investment strategy requirements)".

Where assets are concentrated in a single investment, it is expected that the trustee will devise a plan to ensure that the risk to the members arising from the concentration will be reduced over a period of time.

SMSF limited recourse borrowings risk management

Borrowing to invest involves additional risk to retirement benefits. The limited recourse nature of SMSF borrowings as required by legislation limits the risk of loss to the asset acquired under the borrowing arrangement.

Risk management involves a plan or control in place to manage the risks.  SMSFs that borrow to invest should have risk management controls in place to manage the risks associated with borrowing that are consistent with the investment strategy.  It is possible to have a separate risk management statement but this is not a mandatory requirement for SMSFs.  SMSFs can have the risk management plan or mechanism included in the investment strategy.
   
Risks in relation to borrowing

Some of the risks associated with SMSF borrowings include:

1.    Market risk:  risk of capital and income loss due to market downturns or external circumstances. Borrowing increases the funds available to invest but potentially magnifies the extent of the loss if it occurs.

2.    Risk of non-diversification: risk of over concentration in one sector.  Asset classes have different characteristics that may be affected by certain events or changes.

3.    Interest rate risk:  risk of increase in interest rates affecting the ability of the fund to discharge its interest liabilities.

4.    Liquidity risk:  risk of loss from delays in converting an illiquid investment to cash and jeopardise the ability of the SMSF to pay benefits and discharge liabilities.

5.    Cash flow risk arising from periods of property vacancies or other factors that have an impact on the fund’s ability to service repayments on a timely basis.

Risk management
Risk management involves a plan or controls in place.  Generally, it is not good practice or sufficient to provide vague or generic statements that may or may not materialise.  In a well formulated strategy, the plan or controls have to be documented.

Below are some examples of how specific risks can be managed.

• To address cash flow risk, the plan may involve a cash buffer to augment income to service repayments if the need arises.
• To address liquidity risk, the member may have specific funds outside superannuation to be injected into the fund via contributions if required.
• To address the risk of non-diversification, a plan may be in place to utilise future contributions (with possible indicative projections) to invest in specified asset classes through, for example, dollar cost averaging.

It is important to realise that while the trustee has to implement the investment strategy, it is a dynamic document that can be changed as and when the need arises.  Monitoring is another important aspect of the SMSF investment strategy process. The investment strategy should be reviewed at least annually.

Should you require any assistance with legal and regulatory compliance of SMSF investment strategies, please contact us on (02) 8296 6222.