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SMSFs no risk to the system

Andrea Slattery takes a look at what government departments and key regulators are saying about the SMSF sector in their submissions to the Financial System Inquiry.

Reading submissions to the Financial System Inquiry (FSI) can give an excellent insight into the thinking of our senior regulators and government departments charged with overseeing the superannuation system.

It’s for this reason I decided to see what Treasury, the Reserve Bank of Australia (RBA) and the Australian Prudential Regulation Authority (APRA) had written about SMSFs in their detailed submissions to the FSI. After all, of late it seems there has been no shortage of critics of the SMSF sector; indeed, some have even gone as far as to suggest they pose a systemic risk to the financial system. So surely if there were merit in these claims, those charged with overseeing the system would have a view; a strong view.

So what have they said? Let’s start with this quote from Treasury. “SMSFs allow super funds to manage their own retirement income if they choose to, and enhance competition within the super section. They involve no financial promise – intense or otherwise – as the beneficiary and trustee are the same person and are not prudentially regulated. As such, SMSFs are appropriately subject to low levels of regulation and oversight by the Australian Taxation Office (ATO) to monitor compliance with the taxation law. This approach should be maintained.”

The RBA devoted an entire chapter to systemic risk, detailing the potential threats to our financial system. Yet SMSFs, with $558.5 billion in funds under management at 31 March, according to the latest ATO figures, hardly rated a mention. APRA, too, failed to use its submission to make a case against SMSFs. It seems Treasury, the RBA and APRA are not losing any sleep over SMSFs.

Perhaps that’s not so surprising. In the run-up to the Cooper inquiry, and post the global financial crisis, there was a similar discussion around the risks SMSFs posed to the system. Cooper himself let it be known at the outset of the inquiry that all bets were off the table in regards to SMSFs; until, of course, he handed down his final report in July 2010 and gave SMSFs a clean bill of health. A bit of tinkering here and there, but essentially the evidence showed SMSFs were functioning well. Just recently Cooper bought back into the argument when he said the regulation of SMSFs should be the responsibility of the ATO.

A claim often made by critics of SMSFs is that the ATO is the sole overseer of SMSFs. It’s factually wrong and, just as importantly, wrongly infers the ATO is failing in its duty.

To begin with, both the Australian Securities and Investments Commission (ASIC) and APRA do have roles in the governance of SMSFs. ASIC regulates the provision of financial advice and sale of financial products to SMSF trustees, as well as the financial markets that SMSFs invest in. And ASIC is now considered under-resourced. It’s pertinent to ask what 500,000 SMSFs would do to its resources and the pressure it is under with further staff cuts in the pipeline.

APRA regulates the banks that provide a number of deposit, custodian and lending services to SMSFs. And critics who suggest APRA should administer SMSFs instead of the ATO should reread the Wallis inquiry: its report said APRA was ill-equipped to manage a sector with more than 150,000 entities at that time (it has since grown to more than 500,000). Logically the ATO is one of the few government bodies actually structured to handle the volume.

Asset allocation is often cited by SMSF critics as evidence of systemic risk. Yet the evidence simply doesn’t bear this out. In terms of performance, SMSFs tend to outperform the APRA-regulated funds when markets are underperforming (reflecting their more conservative asset allocation) and typically are on par with the APRA funds in good times. According to a report by National Australia Bank, SMSFs have significantly outperformed their APRA-regulated rivals in six out of the past eight years surveyed. An APRA survey also has cast SMSF returns in a good light.

So why do SMSF trustees get such bad press on asset allocation? First, many are innately conservative investors; the latest ATO figures still have SMSFs holding 28 per cent cash and fixed-term deposits, in itself not a bad thing if the concern is with systemic risk. Their equity investments focus on blue-chip Australian equities paying franking credits – a logical investment option for trustees seeking the best after-tax returns. Concerns about property are overplayed. Latest ATO figures show residential property at only 3 per cent of all SMSF assets and limited recourse borrowing arrangements are 0.5 per cent of assets. Remember too SMSFs face barriers to certain types of investment such as infrastructure assets.

Trustees, many of whom are nearing or in pension phase, are undoubtedly attracted to investments they know; bonds and international shares, for example, only comprise a minute fraction of their assets. But give them time. ETFs and an emerging bond market will allow for greater diversification, as will disruptive technology that will open new markets to SMSFs at lower costs, such as the new Australian Securities Exchange mFunds Settlement Service.

The real story is SMSFs have a diversified asset allocation spread across more than 500,000 funds that adds to the robustness of the Australian financial system by reducing the concentration of investment risk in the superannuation sector. The diversification among SMSFs maintains an important bulwark to a concentration of superannuation investments. And it seems the regulators and Treasury agree.

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