A variety of superannuation reserves has been used for a significant period of time. In this two-part feature, Grant Abbott examines how they work and the value they can add to SMSFs.
Reserves have a long history within the insurance and superannuation industries. Used by trustees of employer superannuation funds to self-insure, smooth investment returns, pay temporary incapacity pensions and even hold onto surplus contributions, they have now become a mainstay of industry-based superannuation funds. Also long the preserve of life insurance companies, reserves were determined each year by actuaries as surplus to the needs of the insurance company to meet all potential claims, given the mortality and other risks of its policyholders. In the 1980s, many life insurance offices won clients by offering bonuses to policyholders out of accumulated reserves.
SMSFs have also been in the reserve game since 1994 when excluded superannuation funds were first introduced into Australia. In the 1990s, the key reserving strategies used by accountants, financial planners and fledgling SMSF advisers were:
- reasonable benefit limit (RBL) minimisation – this allowed the forfeiture of benefits from one member’s account to a reserve, thereby limiting the amount sitting in a member’s account,
- benefit smoothing – this generally followed on from the RBL minimisation strategies, whereby amounts sitting in a reserve, typically known as an equalisation reserve, were credited to the account of the spouse member in the fund with the least benefits,
- returns smoothing – earnings from the fund’s investments were and continue to be taken to an investment reserve for the purpose of smoothing returns over a period of time. In years of good investment returns, allocations are made to an investment reserve to build up a surplus such that in bad investment periods an amount can be allocated from the reserve to minimise or prevent the reduction of a member’s superannuation benefits, and
- surcharge minimisation – at the time of the introduction of the superannuation surcharge contributions tax, member contributions could be credited directly to a reserve and allocated to a member account at a later time. It was only at the time of allocation from a contributions reserve to a member’s account that the allocation became a surchargeable contribution. This allowed a trustee of an SMSF to ensure members could effectively defer the superannuation surcharge.
Many of these strategies were lost with amendments to the Superannuation Industry (Supervision) (SIS) Act in 2004 preventing forfeiture of benefits and the requirement to allocate a member contribution within 28 days after the end of the month in which a contribution is made. For many years SMSF reserving was very quiet – until the introduction of the Simpler Super regime in 2007. It can now be said SMSF reserving strategies have become vitally important for tax and estate planning purposes in the large majority of SMSFs. But for many practitioners they can be a confusing and challenging opportunity that is often better left alone than learning and putting the knowledge into application.
Important note: There is a significant sting in the tail with reserving strategies in that section 292.25 of the Income Tax Assessment Act 1997 provides that an allocation from a reserve is, prima facie, a concessional contribution. For those financial planners, accountants and other advisers not in tune with all facets of a fund’s trust deed, the relevant legislation, the exemptions from the concessional contributions tax, reserving actuarial requirements and what specific documentation is needed in terms of creating, allocating to and allocating from a reserve, SMSF reserving can be a time bomb.
What is a superannuation fund reserve?
In an Australian Prudential Regulation Authority (APRA) superannuation prudential practice guide, SPG 235, on “The Use of Reserves in Superannuation Funds”, the regulator provides the following in relation to reserves and superannuation funds (excerpts with paragraph highlighters shown):
1. Section 115 of the SIS Act allows trustees of superannuation entities to maintain reserves provided that the entity’s trust deed does not prohibit reserves. If any reserves are maintained, the trustee is bound by the covenant in paragraph 52(2)(i) of the SIS Act to formulate and give effect to a strategy for their prudential management, consistent with the entity’s investment strategy and its capacity to discharge its liabilities (whether actual or contingent) as and when they fall due. For SMSF trustees the relevant section for reserving strategy is section 52B(2)(g).
2. Reserves are not defined in the SIS Act. Reserves in a superannuation fund can be regarded as monies which form part of the net assets of the fund and which have been set aside for a clearly stated purpose. This may be, for example, to assist in the equitable management of fund earnings (an investment fluctuation reserve) or the management of contingencies (an operational risk reserve) or a self-insurance reserve. Reserves are largely concerned with contingent events and, as such, the trustee needs to exercise judgment in determining the need for them, and their scope, size and operation.
3. In many cases (for example, an operational risk reserve), the reserve will act to spread potential costs across different ‘generations’ of fund members. For example, fees charged to members may help build up a reserve, but some members may leave the fund before the occurrence of the contingent events for which the reserve has been established. There is no inherent inequity in this approach to spreading costs over time or generations of members, given that all members potentially benefit from the intended smoothing effect, even if the contingencies do not eventuate during the membership of a particular cohort.
4. APRA has observed that some trustees have decided that the use of reserves is an appropriate way to ensure equity between various groups of members. APRA expects that a prudent trustee, in deciding whether or not to maintain reserves, will at all times be mindful of their obligations, as set out in the covenants in section 52 of the SIS Act, to act in the best interests of beneficiaries and to keep the assets of the fund separate from other assets of the trustee, or of a standard employer-sponsor or an associate of a standard employer-sponsor.
5. Where reserves are maintained, APRA expects that a comprehensive management strategy would exist and would contain appropriate objectives for which the reserves are established as well as measures to manage the reserves. Before establishing a reserve, it is important for a trustee to be clear on why the reserve is to be established, and its ongoing purpose. A trustee may establish a separate reserve for each identified risk or may cover more than one risk through a single reserve account. The trustee would need to consider, however, whether it is appropriate to use a single reserve to cover the identified risks where they are fundamentally different in nature, which could make it difficult to manage the reserves prudently over time.
6. Measures which APRA would regard as sound practice in a reserving strategy include the following:
- clear definition by the trustee of the purpose, or purposes, of each reserve;
- balancing of the number of reserve accounts against risks identified by the trustee, and
- establishing whether, and under what conditions, amounts may be transferred from one reserve account to another;
- determination by the trustee of the appropriate levels or range of each reserve, including how and over what period the reserves are to be funded or built up, the rematching of actual levels to target levels after a drawdown from the reserve, whether a reserve can have a negative balance and the maximum duration of any negative balance;
- clear linkage between the permissible range of values of the reserve, whether expressed in dollars or percentage of assets of the fund or relevant subfund, and the nature of the risk, or risks, it is designed to address;
- where a reserve is specific to a particular subfund of the fund, effective mechanisms to ensure the reserve is quarantined to that subfund;
- periodic review to ascertain that each reserve remains appropriate to the circumstances of the fund;
- controls and procedures implemented by the trustee to ensure that reserves are used only for the intended purpose or purposes;
- the manner of distribution when a reserve is no longer required, and
- proper identification of the reserves in the accounts of the fund.
In terms of SMSFs, the ruling regulator is the commissioner of taxation. However, in many rulings and guidelines on general superannuation matters, as opposed to the application of the laws of taxation, the commissioner defers to guidelines for the management of a superannuation fund as pronounced by APRA.
The new SMSF and why reserves makes it work
To put it simply, reserves take a typical SMSF from being a fixed trust to one that provides a degree of discretion and flexibility. For example, part 5.03 of the SIS Regulations 1994 treats an accumulation superannuation fund differently to an accumulation fund with reserves when it comes to the distribution of investment returns by the trustee of the fund.
In terms of crediting investment returns to member accounts, an accumulation superannuation fund is required to distribute all investment returns on a ‘fair and reasonable’ basis. In contrast, the trustee of an accumulation fund maintaining reserves “must determine the investment return to be credited or debited from time to time to a member’s benefit (or benefits of a particular kind) in the fund, having regard to:
- the return to the fund on investments; and
- the extent to which the costs of the fund exceed (or fall below) the aggregate of the costs charged to member’s benefits under regulation 5.02; and
- the level of the reserves of the entity.”
Subject to the fund’s trust deed, regulation 5.03 provides the trustee with the flexibility of carrying earnings of the fund to a reserve with any remainder to be distributed among member accounts in the fund by the trustee on a fair and reasonable basis.
Case study knowledge tester – allocation from an investment reserve
You have just won a new client – the Jones SMSF. Following three meetings and not much help from the fund’s former accountant, you find out the following.
The Jones SMSF was established in 2004. Since that time the financial planner and accountant to the fund have been allocating 20 per cent of its earnings to an investment reserve created at the time.
Following a review of the fund’s trust deed, last upgraded in 1998, you find the trustee of the fund can maintain an investment fluctuation reserve only. The rules provide as follows:
Rule 3.3 The trustee of the fund may maintain an investment fluctuation reserve to which amounts can be added from fund investments and the trustee may allocate for whatever purposes it considers appropriate, subject at all times to the requirement of the relevant law. The purposes may include smoothing the earnings rate of the fund from time to time.
A separate investment strategy for the reserve has been completed by the fund’s financial planner investing in an Australian bond fund and for the year ended 30 June 2014 the SMSF’s audited accounts show an investment reserve of $230,000.
There are two members of the fund, Sam and Pat Jones, both aged 56, with Sam in receipt of a transition-to-retirement income stream valued at $400,000 with a tax-free/taxable proportion of 60 per cent/40 per cent. Sam also has a lump sum accumulation account with $120,000 that is all taxable. Sam has his own business and will continue to contribute to the fund wherever possible. Pat is retired and has an account-based pension of $350,000 (50 per cent tax-free/50 per cent taxable component) – although no pension documentation has ever been drawn up. The fund runs a pooled investment strategy for all superannuation interests, with an allocation of 70 per cent to Australian equities and 30 per cent to cash.
With the market downturn, Sam and Pat’s account balances have lost 15 per cent of late and the SMSF trustees, Sam and Pat, are looking to allocate some of the investment reserves to their pension account balances only.
Your task: Come up with a best strategy for the reserves. We will provide the various options in the next edition of selfmanagedsuper.
