Implementing An SMSF Investment Strategy
All self managed super funds are required to formulate and give effect to an investment strategy. This is a requirement under section 52 and regulation 4.09 of the SIS Act, introduced in 1996. Investment strategies provide a road map for trustees and formalize the investment process for the life cycle of the fund. It can be changed from year to year subject to the financial position of the fund. The SMSF investment strategy must reflect the purpose and circumstances of the fund and consider:
The risk involved in making, holding and realizing, and the likely return from, the fund’s investments having regard to its objectives and its expected cash flow requirements;
Appropriate diversification and the benefits of investing across a number of asset classes (e.g. shares, properties, fixed deposit);
The ability of the DIY super fund to pay benefits as members reach retirement and other costs incurred by the fund;
the composition of the fund’s investments as a whole including the extent to which the investments are diverse or involve the entity in being exposed to risks from inadequate diversification;
The liquidity of the fund’s investments having regard to its expected cash flow requirements; &
The ability of the fund to discharge its existing and prospective liabilities, such as administration expenses and other outgoings. The fund is a defined contribution fund and the members are entitled to the accumulation of contributions and earnings in the members’ account on withdrawal. The fund will be able to meet its obligations to the members at all times.
Objectives of an investment strategy
The investment strategy should guide trustees with investment objectives. Some examples of general objectives can be:
- To provide retirement benefit for the members. In the event of the members’ death before retirement, to provide benefits for the dependants of the members;
- To ensure that sufficient assets will be available to meet benefit payments when those payments are due to be paid (solvency); &
- To ensure that sufficient liquid assets will be available to meet benefit payments as and when those payments are due to be paid (liquidity).
Some examples of specific objectives can be:
To achieve a long term rate of return in excess of the CPI. It is expected that year-on-year returns will vary widely and that there will be years when returns are negative; or
To achieve cash plus related returns subject to the requirement that the capital value of the Fund is preserved in the short term; or To outperform the ASX 200 by 2 percent over the next three years; or
To ensure sufficient cash balance to meet minimal pension requirement; or
To achieve cash related returns subject to the requirement that the capital value of the fund is preserved at all times, and to avoid negative return; or
To achieve long term returns slightly above those of the bond market. It is expected that year-on-year returns may vary with there being only a small probability of negative return in any one year; or
To achieve a long term rate of return approximately equal to CPI. It is expected that year-on-year returns will vary considerably with a moderate probability of a negative return in any one year.
Trustees should ensure objectives are realistic and achievable. Where objectives are not met, the investment strategy would provide a source of reference for trustees to revisit and reconsider whether the SMSF should be rebalanced or the objectives left unchanged. An investment strategy should establish the approach to investment of the fund reflecting the profile of fund members. While not a formal requirement, such an investment strategy should be in writing and documented. This will serve to justify any investment decisions made by trustees whenever compliance issues are questioned during the annual audit of the fund. More importantly, it is the easiest way to meet the requirements of Section 52.
Contrary to popular opinions, there are no quantitative or qualitative restrictions on the investment decisions of DIY super funds, other than the following limitations:
- The sole purpose test;
- Acquisition of assets from members;
- Financial assistance to members; &
- In-house assets rule
For example, self managed super funds can invest all its monies in business real property held in a foreign country. Whether it is a prudent investment decision is another issue. The Superannuation Industry Supervision Act 1993 does not prescribe any criteria to assess risk, return on investment or diversification.
Risk profile of an investment Strategy
The member’s attitude towards risks and the life cycle of the fund can be used as determinants for the profile of the fund. For example:
- The members are close to retirement and expect the fund to invest in risk adverse investments to achieve capital preservation and avoid volatility in returns;
- The fund has a relatively long time horizon. The members are prepared to endure a reasonable level of volatility of returns in expectation of long term growth;
- The composition of the members is diverse and the collective risk tolerance indicates that there should be a balance of reasonable risk and volatility to achieve long term capital and income growth;
- The fund is paying a pension income stream(s). Investments should be made in risk adverse investments, which combine reasonable security of capital with the prospect of long term growth, with the view to prolonging the duration of the pension payments;
- Investment risk is borne by the members, as fluctuation in investment returns will affect the level of the members’ benefits on withdrawal; &
- Investment risk is borne by the members, as fluctuation in investment returns will affect the level of the members’ benefits on withdrawal. The fluctuation is smoothed by the maintenance of a reserve to which returns are credited or debited according to the credit rate policy.
Liquidity issues to consider for an investment strategy
The investment strategy is required to take into consideration liquidity issues to meet ongoing expenses of the fund. There is no specific requirement that a DIY super fund must invest in liquid assets such as:
- cash at bank;
- term deposits; or
- other interest bearing securities.
However, trustees should take into consideration the different stages in the life cycle of the fund. Where the fund members can assume more risk, such as young people starting out in the work force, growth assets such as blue chip shares or residential investment property may be a more prudent investment option. On the other hand, where the fund members are considering transitioning to retirement, rebalancing the fund portfolio to include a certain balance of cash deposits may be more prudent. A cash management account paying a high interest yield may also be ideal for younger investors who need to park their investment somewhere until the right opportunity is identified.
Examples of statement on liquidity can be:
- There is no anticipated benefit payment in the next five years. Cash in excess of anticipated liquidity requirement will be invested in accordance with the fund’s investment strategy;
- Lump sum benefit payment will be made. The Trustee will monitor the liquidity position to ensure that there will be sufficient liquid assets to meet the benefit payments as and when they fall due; &
- Pension payments are made at least annually. The trustee will monitor the liquidity position to ensure that there will be sufficient liquid assets to meet the benefit payments as and when they fall due.
Diversification issues to include in the investment strategy
There is no specific requirement for DIY super funds to diversify its investments. However, it may be a prudent strategy as the size of the fund grows. Diversification is about spreading the risk across a number of assets as well as across asset classes. For example, if trustees consider blue chip banking shares to be a safe performing asset class, it may be prudent to diversify across the major banks – CBA, ANZ, Westpac, NAB and Macquarie. While such diversification means the investment portfolio is still subject to the same economic risk such as domestic government fiscal and monetary policies, it does minimize specific company risks. Macquarie Bank is an investment bank, trading in foreign currency and derivatives, and as such higher risk may translate to higher return on investment for investors. In addition, trustees can also diversify away specific country risk by investing in overseas banking shares. For example: HSBC, Bank of China or ING bank, to name but three.
Diversification is about minimizing company and industry specific risk. However, trustees should be mindful about the number of assets to diversify across. Once a fund reaches 50 investments or more, it would still be subject to the same country specific risk, which cannot be diversified away. Trustees should weigh up the benefits and costs of administering such a large portfolio. A statement on diversification of the fund can be:
- Diversification is achieved through a mix of Australian investments across a range of asset classes. The trustee recognizes that diversification can result in significant reduction to return volatility while maintaining the level of anticipated return;
- The funds are primarily invested in fixed interest securities and deposits. It is considered that investment in this asset class is suitable for the fund’s policy of maximizing capital preservation and avoiding negative return;
- The funds are primarily invested in equities. The trustee recognizes the higher risk in investing predominantly in only one asset class and the volatility associated with shares. The volatility will be compensated by the prospect of achieving higher return and growth in the longer term. The shares are invested in different industries and sectors, which will spread risk to a satisfactory level;
- Diversification across currencies, economies and asset classes is achieved through a mix of international and Australian investments. The trustee recognizes that diversification can result in significant reduction to return volatility while maintaining the level of anticipated return;
- The fund is invested in a Unit Trust and the underlying assets of the trust are primarily invested in shares. The trustee recognizes that the fund is subject to higher risk associated with investing predominantly in one asset class and the volatility associated with shares. The trustee considers that the higher risk will be compensated by the prospect of achieving higher return and growth in the longer term. The shares are invested in different industries and sectors, which will spread risk to a satisfactory level;
- The fund is invested in a Unit Trust and the underlying asset of the Unit Trust is an investment in an investment property. The trustee recognizes that the fund is subject to a high level of property specific risks. The trustee considers that real property is a secure investment with the prospect of long term capital appreciation while generating steady income growth; or
- The fund is invested primarily in one real property. The trustee recognizes that the fund is subject to a high level of property specific risks. The trustee considers that real property is a secure investment with the prospect of long term capital appreciation while generating steady income growth.
Documentation to support an investment strategy
Trustees are encouraged to keep other source documentation to support the investment strategy. This is of greater significance for unusual investments that include: artworks, jewelries and related party transaction such as leased premises to employer sponsors. These documentations can include:
- Market appraisal of similar properties and evidence of recent sales;
- Copies of statement of advice (SOA) from financial planners to justify the acquisition or disposal investments; &
- Minutes of meetings linked to the overriding investment strategy to suggest alternative investments have been considered and reviewed on a regular basis.
The formulation and implementation of the investment strategy should be viewed as an ongoing process that can be subject to change. The whole premise of the investment strategy is to support the decisions made by trustees having taken into consideration:
- Risk profile;
- Expected return;
- Diversification; &
Any significant change in investment decisions should be updated and reflected in the investment strategy. For example, if the fund switches from domestic shares to residential investment property, then the minutes of meetings should document the reasons for the change.
Seeking Independent Advice
Fund trustees have a preference for being in control and making their own decisions. For this reason trustees tend not to seek any independent advice often feeling frustrated at the lack of independence, requisite skills and objectivity displayed by advisors in the financial planning industry.
While the skill level and objectivity of financial advisors can be questioned at time, it is recommended that trustees seek independent advice on future investment directions. For example, investors have been promised positive cash flow properties in the form of student accommodations, with the added benefit of taxation benefits. However, such investments often require 40-60% deposits and can only be rented to students and managed by the Student Housing Association (SHA). These restrictions place limitation on the profile of tenants such that should students travel overseas during the festive season, landlords are left with vacancies of 2 – 3 months per calendar year.
Investment in single asset or asset class
This question tends to ebb and flow with the rise and fall in popularity of residential investment property. The short answer is “Yes”. DIY super funds can invest all it monies in a singular investment, provided the investment strategy has made such provisions. Sub-section 52(2)(f) of the SIS Act states that liquidity and diversity of investments should be considered, but there is no compulsion. Both the ATO and APRA (previous regulator of SMSFs), are consistent on this matter. APRA circular No II.D.1 – “Managing Investments & Investment Choice” accepts that trustees may invest all of the self-managed super funds monies in a singular asset or asset class. The ATO supports this view by increasing the investment threshold allowed in “business real property” to 100%, up from 40% prior to 12th May 1998.
Investment in commercial properties can address the issues of capital growth, as well as liquidity. For example, it is a well know fact commercial properties such as office space or factories can command rental yields of 8-10%, provided trustees can secure a long term tenant. This is the case regardless of whether the commercial property is held in the accumulation or pension phase. The 8-10% rental yield would be more than enough to meet the minimum pension draw down limit for a number of years. When it is required to sell down on the commercial property in the pension phase, any capital gains would be entirely tax free!
SATO SMSF Adminstration fund establishment kit would include in the minutes of meetings and documentation for signing, an investment strategy document to be completed as well as an investment strategy template for your retention and future records. Fund auditors are required, as part of their tasks to sign off on the fact, trustees are operating the self-managed super funds in accordance with an updated, documented investment strategy and that your fund is complying with this section of the SIS Act.
Completing the investment strategy will not only confirm your fund’s compliance with the legislation but more importantly further enhance the achievement of reaching your retirement objectives. Every investment (including bank accounts) held by the self managed superannuation must show the correct trustee details and account designation. The correct holding details of all investments held by DIY super funds should be shown as follow:
ATF – As Trustee For; or
‘XYZ Pty Ltd ATF Citizen Family Superannuation Fund’
ATF – As Trustee For
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