Grant Abbott steps through the birth and evolution of SMSFs, as well as what their future might look like if there is a change of government at the federal level.
Superannuation and pension plans have been around a long time. I was first introduced to superannuation as a young tax consultant in the 1980s while working in the finance practice area of KPMG and all my clients had staff superannuation funds. As their tax adviser I had to deal with their superannuation and employee super benefits from a tax perspective. Many of these funds were defined benefit superannuation funds, which provided employees with benefits that became vested dependent upon certain terms and conditions, generally the number of years worked for the company.
Importantly, defined benefit superannuation funds were absolutely controlled by the employer. When you started a new job, after a certain period of service, say a year, you were entitled to join the employer super fund. Then after five years’ service, 25 per cent of your accrued superannuation benefits (a nominal end figure as per the plan) would be vested, so if you left the employer, you could access those superannuation benefits or transfer them to another superannuation fund or life insurance company. The longer you stayed with the employer, the bigger the vesting percentage until after say 25 to 35 years of service the benefits were fully vested. However, once you left the employer there was no right to remain in the fund and you were terminated from it. So the membership of the fund was at the employer’s discretion.
A quick lesson on defined benefit superannuation funds
For the younger advisers out there, defined benefit superannuation funds were the core employment benefit offered by banks, insurance companies and, of course, the public service to their employees. It was prestigious to work for one of these bodies as you were guaranteed a pension. At the end of your working life if you had met a vesting period of say 20 years employment, you were entitled to be paid a pension equivalent to around 70 per cent of your final average salary for the rest of your life with a reversion to your spouse of 75 per cent of the pension. In some superannuation funds the pension could be commuted to a lump sum or there could be a mix and match.
So why aren’t they around anymore? There are a number of reasons:
1. Employer funding
In the days of employer defined benefit funds the employer set up the superannuation fund or pension plan for its employees. It would make contributions based on an actuarial determination of what the fund’s current and future liabilities would be. If the fund was overfunded, which generally meant the underlying investments in the fund had done well and exceeded the actuarial requirements, the employer did not need to contribute. In fact, in some funds the employer was able to take back the surplus from the fund to its profit and loss statement. However, when the investing climate was tough the employer had to top up the fund. Now if an employer was called upon to top up significantly, this impacted on the company’s earnings, and if listed, its share price. For many it was circular as the superannuation fund was able to hold employer stock as its investment. For example, the Fairfax Superannuation Fund was primarily invested in Fairfax stock, which ultimately led to the takeover of the company by Warwick Fairfax in 1987.
SMSFs are not going away and in my view are going back to the future.
However, in the long term, with pension members living longer and reversions to spouses, ultimately the plans were financial suicide for the employer. Remember the pension plan is a promise to pay ex-employees until they die or the employee’s spouse if the employee dies before them. For a company or government this can amount to a significant unfunded pension liability. For example, the Californian pension system is currently unfunded by US$1 trillion. And it is not just there; many countries, states, counties, public offices and companies are still running unfunded defined benefit pension plans around the world. At some point the system will break and hundreds of millions will be left shortchanged, but thank goodness not in Australia.
2. The superannuation guarantee system
The superannuation guarantee system came into effect on 1 July 1992 thanks to the Hawke-Keating government. The system required employers of all types to make direct contribution payments into employer, retail or industry superannuation funds. For defined benefit pension plans this meant the vesting periods that were dependent on length of service were upended.
The system was the death knell for defined benefit superannuation funds as there was a big switch, with incentives for many employees to get out of their employer defined benefit funds and move to the standard superannuation funds we see in place today. Many large companies, including banks and insurance companies, breathed a sigh of relief.
3. Staff mobility
As already discussed, in the days of defined pension plans, employees were rewarded with generous superannuation and pension entitlements depending upon how long they had worked for their employer. My father received a $450,000 lump sum payout in 1988 when he retired from work after 40 years of service to one company. Suffice to say the days of staying with one company for all or a substantial portion of your working life are long gone and the tie up with the pension plan has long been replaced by deferred bonuses to keep good employees.
SMSFs come into play
When my dad retired, he had to take his benefits out of the staff superannuation fund, so we transferred them to a personal approved deposit fund, which was a one-member account run by an insurance company enabling him to choose his investments. In 1988, there were a number of small super funds run by employers and it is fair to say a lot of them were set up as cherry-picker funds.
What’s a cherry-picker superannuation fund?
Well, a small business would set up a fund, make tax-deductible contributions to the fund on behalf of all employees, but with vesting schedules that made it impossible for the employees ever to receive their benefits. And in cases where it looked as though an employee might make their full vesting, they were transferred to an associated company and thereby lost their superannuation benefits. In essence, all the tax-deductible contributions were cherry-picked for the business owners. And, of course, the investments in the fund included company shares or loans (this was prior to in-house assets). A classic illustration of this is found in the Swiss Chalet case of 1995, where the assets of the fund included a Swiss chalet, a holiday home at Rosebud and a golf club membership – all sponsored on the back of tax-deductible contributions, but ultimately held to be in breach of the sole purpose test.
If Labor is voted into power at the election on 18 May, SMSFs are in the firing line.
On 1 July 1994, the Superannuation Industry (Supervision) (SIS) Act 1993 came into play. I remember it well, having made numerous submissions on the bill, including why it forced funds with individual trustees to pay pensions only (section 19). Importantly, it introduced the first ever four-member superannuation fund, the excluded superannuation fund, which turned into the SMSF in 1999 when jurisdiction for these funds transferred from the Australian Prudential Regulation Authority to the Commissioner of Taxation.
On 1 July 1994, small superannuation funds under the old Occupational Superannuation Standards Act 1986 were able to elect to become excluded superannuation funds and 70,000 did with $11 billion in assets. With that the SMSF industry was born. I was lucky enough to be there from the beginning and in 1995 when working for Rothschild Asset Management as head of superannuation I made the first ever SMSF video extolling the tax benefits and virtues of setting up this type of fund. By that time allocated pensions were all the go and a number of larger superannuation balances, like my father’s, were transferred into the first ever SMSFs.
In the first few years it was a grand old time. Think of some of the SMSF investments that were popular then, but you certainly could not get away with now:
- a unit trust that the SMSF trustee owned and could borrow from and invest in shares, property and really anything, including property rented to children,
- lease fit-out and fittings leased back to an employer contributor, and
- investing in art work or cars held at the business or personal premises of a member.
The number of funds grew quickly and a few were set up not for mum and dads, but business partners. The iconic business partner case of Dunstone v Irving  VSC 488 involved an SMSF with a partnership breakdown that saw major problems in the fund. It is essential reading and in my top five cases for all SMSF advisers to read, particularly as it relates to section 55(3) of the SIS Act and the exposure for advisers to damages and losses stemming from an adviser breach of the governing rules of the fund.
But 1999 came around and with the switchover to the ATO as the regulator, along with a tightening of the in-house asset rules to include related trusts, leases and lease arrangements, planning was made harder. But they still grew and grew and with then treasurer Peter Costello making super tax-free after the age of 60 in 2007, along with the abolition of the reasonable benefit limits (RBL) and a generous $1 million non-concessional contribution offering to 30 June 2007, SMSFs absolutely took off. The rest as they say is history – well not really.
SMSFs with a new Labor government
If Labor is voted into power at the election on 18 May, SMSFs are in the firing line. Here are some of their proposals and my predictions:
- the non-concessional contribution cap will go down to $75,000 from 1 July 2019. Expect it to go even lower in the future and a $50,000 cap is not out of the question within three years,
- the immediate abolition of limited recourse borrowing arrangements where we will be looking at any closing of loan refinancing,
- the imposition of maximum benefit limits just like the old RBL,
- a limit of $500,000 on the amount that is needed to establish an SMSF,
- assessment of compliance of an SMSF before a member may transfer from an industry super fund to an SMSF, including possibly a mandatory education test,
- the five-year unused concessional contribution catch-up to go,
- refundable franking credits to go from 1 July 2019,
- stricter training guidelines on advice to set up and manage an SMSF, and
- a bigger budget for the Australian Securities and Investments Commission to chase down SMSF promoters who operate outside the Corporations Act 2001.
The future of SMSFs
SMSFs are not going away and in my view are going back to the future. In my next article I will be delving into a new style of super fund, the leading member SMSF, for which I have the Queen of the United Kingdom to thank. As SMSF advisers we need to deal with what we have in front of us and continuously improve and innovate. Without that we need to be simply doing administration.