All SMSFs are required by law to formulate and adhere to an investment strategy. In this two-part feature, Grant Abbott details the various components, both legislative and otherwise, to take into account when creating this critical element of an SMSF.
An investment strategy is a plan established by the trustee of a superannuation fund to achieve one or more investment objectives and primarily for one or more superannuation purposes.
Importantly, the trustee is required by the Superannuation Industry (Supervision) (SIS) Act 1993 to not only document an investment strategy, but also to ensure it is implemented. In terms of superannuation, nothing could be more fundamental to achieving the transition-to-retirement, retirement and estate planning goals of a member of the fund.
If the trustee or their SMSF adviser is complacent in terms of meeting the investment strategy responsibilities, the fund may flounder in terms of meeting its investment objectives and, more importantly, may become a non-complying SMSF, thereby jeopardising all of the members’ benefits in the fund.
As a fundamental component of the SIS Act and the governing rules of the fund, if the trustee or the fund’s investment adviser invests outside the parameters of the investment strategy, section 55(3) of the SIS Act allows the members of the fund to recover from ‘any person’ who has breached the investment strategy rules.
So treat investment strategies without the proper respect at your peril.
However, an investment strategy can be very strategic. For example, a strategy being used by experienced SMSF advisers is for an employee over the age of 55 to live on their maximum transition-to-retirement income stream (TRIS) and supplement it with salary and wages, while contributing surplus salary into superannuation both underneath and beyond the concessional contributions caps.
That leaves the employee member of the superannuation fund with two superannuation interests – one, an accumulation fund with a desire to maximise growth, minimise income and taxation, with the other the TRIS, with a need for 10 per cent income payouts.
A pooled investment strategy for the fund gives short change to the strategy, while segregated or separate investment strategies for both superannuation interests can have a significant impact on the member and their long-term superannuation wealth.
Put your mind to the test – what asset allocation, investment and tax profiles would you recommend for the accumulation investment strategy and the TRIS?
What is an investment strategy?
In general, an investment strategy is a forward-looking process put in place by the trustee of a superannuation fund governing what the fund is going to invest in over a future period of time.
Retail and industry superannuation funds generally maintain very detailed investment strategies that provide a specific investment objective, such as obtaining an investment return of consumer price index plus 2 per cent, for example, and then setting asset allocation benchmarks as a strategy to meet that objective.
There are also significant prudential requirements that a trustee of an Australian Prudential Regulation Authority (APRA)-regulated superannuation fund must adhere to.
In contrast, trustees of SMSFs prepare backward-looking investment strategies – that is, a strategy documenting the trustee’s intentions 12 to 18 months after the event. Looking at the APRA standards, this is clearly not an investment strategy but an investment record. Likewise, those that set strategies for a future period with all asset allocation class investments set at an allowable 0 to 100 per cent investment potential by the trustee of the fund are probably not identifiable investment strategies – again not in APRA’s thinking.
Certainly it is one for the courts to decide in terms of SMSFs.
So let’s look at the investment strategy requirements and fundamentals for the trustee of an SMSF, their advisers, administrators and auditors.
The SMSF compliance process
When looking at any question to do with an SMSF, there is a five-step compliance process that needs to cover the following five key compliance areas at the very least.
The trust deed of the fund
It is surprising that many SMSF practitioners and accountants, let alone auditors, who are required by law to review a fund’s trust deed, are ignorant or oblivious to the internal workings of this crucial document. Many older SMSF trust deeds are based on employer trust deeds from the 1990s and do not allow separate investment strategies, which may cause a problem in a mixed fund, that is, a fund with both accumulation and pension superannuation interests.
So the first step is always to check the fund’s deed. What are the requirements in terms of the trustee’s investment powers and, more importantly, what is the trustee required to do to meet investment strategy requirements under the deed? In this particular case, the practitioner should check whether a separate investment strategy can be run for one or more pension members of the fund.
Important strategy note: Section 52B(1) of the SIS Act provides that “if the governing rules of an SMSF do not contain covenants to the effect of the covenants set out in this section, those governing rules are taken to contain covenants to that effect”.
To that end, sub-section 52B(2)(f) provides that it is a requirement for the trustee to formulate, review regularly and give effect to an investment strategy (see in more detail below).
In short, this means if the fund’s trust deed is silent in terms of investment strategies and the other trustee obligations under section 52(2), then the SIS Act operates to insert the investment strategy requirements of sub-section 52B(2)(f) into the fund’s governing rules – ordinarily the deed.
From a practitioner’s perspective, it is one of the only times the SIS Act overrides the trust deed of the fund. However, the section in question does not provide the trustee with the automatic authority to run separate investment strategies for the fund or even a specific member pension interest. This is to be found under the deed.
2. Corporations Act 2001
There are strict requirements for advisers, accountants and any person dealing with a financial product.
In terms of financial products, section 763A(1) of the Corporations Act 2001 provides a general definition of what a financial product is. In particular, sub-section (1) states that a financial product is a facility through which, or through the acquisition of which, a person does one or more of the following: a) makes a financial investment, b) manages financial risk, or c) makes non-cash payments.
Looking specifically at sub-paragraph (a) and the term “making an investment”, section 763B defines it as where:
a. the investor gives money or money’s worth (the contribution) to another person and any of the following apply:
b. the other person uses the contribution to generate a financial return, or other benefit for the investor,
c. the investor intends that the other person will use the contribution to generate a financial return, or other benefit for the investor (even if no return or benefit is in fact generated),
d. the other person intends that the contribution will be used to generate a financial return, or other benefit, for the investor (even if no return or benefit is in fact generated), and
e. the investor has no day-to-day control over the use of the contribution to generate the return or benefit.
So advising a trustee of an SMSF to acquire a specific share, such as a particular share, is providing advice on a financial product and thus the person advising would need an Australian financial services licence. In contrast, advising on an investment property is excluded because the SMSF trustee would have day-to-day control over the use of the investment.
Of course, the property adviser may need to meet a raft of other regulatory guidelines, just not the licensing guidelines.
Advising on an investment objective and investment strategy, without making any specific investment recommendations, would not appear to be advice about making a financial investment.
Technical note: Section 764A of the Corporations Act includes specific investments or products as “financial products” for the purposes of the act. From an SMSF perspective, section 764A(1)(g) provides that a superannuation interest within the meaning of the SIS Act is a financial product.
In that regard, turning to section 10(1) of the SIS Act, the definition of a superannuation interest means a beneficial interest in a regulated superannuation fund. As such, any interest in an SMSF is deemed to be a financial product for the purposes of the Corporations Act – this includes making a contribution, taking a lump sum and commencing a pension.
However, it deals with the making of a recommendation to the member of a fund and not the trustee as is the case with an investment strategy.
3. SIS Act
The investment strategy rules can be found in section 52B(2)(f) of the SIS Act and also SIS regulation 4.09 that, in regard to an SMSF, stipulate:
“The trustee of the entity must formulate and give effect to an investment strategy that has regard to all the circumstances of the entity, including in particular:
a. the risk involved in making, holding and realising, and the likely return from, the entity’s investments, having regard to its objectives and expected cash-flow requirements;
b. the composition of the entity’s investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification;
c. the liquidity of the entity’s investments, having regard to its expected cash-flow requirements;
d. the ability of the entity to discharge its existing and prospective liabilities.”
In that regard, the commissioner of taxation has declared to SMSF trustees “the investment strategy should set out your investment objectives and detail the investment methods you will adopt to achieve these objectives. It must be reviewed regularly and whenever there is a change to the fund – for example, when a new member joins. You need to make sure all investment decisions are made according to the investment strategy of your fund.”
The SIS Act is generally silent in terms of establishing, running and maintaining a separate investment strategy for SMSFs, but for larger funds there is the member choice method where the trustee may offer members of the fund a choice of investment strategies.
This is a complex process, which involves the trustee establishing more than one broad investment strategy for members.
The trustee is also required to notify the members of other information that “the trustee reasonably believes a person would reasonably need for the purpose of understanding the effect of, and any risk involved in, each of those strategies’’ (section 52(4) of the SIS Act and SIS regulation 4.02). Once all members are notified of their options, each member must then choose and notify the trustee of their choice.
Example
The SIS Regulations give the following example as indicative of member choice:
A strategy could allow the beneficiary, or class of beneficiaries, a choice in exposure to certain classes of assets. The beneficiary may choose 60 per cent in fixed interest investments and 40 per cent in shares.’’
Member choice in this instance is more appropriate for funds where there are thousands of members, whereas for a family SMSF, there is too much administration to make this a viable method for providing separate and segregated investment strategies, and is generally not recommended.
As noted earlier, it is important for the trustee to be given a specific power under the trust deed of the fund to formulate separate and segregated investment strategies for each member, or class of members, in the fund or in respect of a particular member’s benefit.
Under this power, separate and segregated investment strategies are provided for members, however, the trustee controls all investment strategies in the fund. It is important to note the members of the fund may have input into which assets are to fill their investment strategy, but the trustee is not obliged to take into account their wishes.
In the second part of this feature, we will examine the impact of the Tax Assessment Act on the investment strategy and the compliance documentation required.
