For many small to medium-sized enterprises (SME) or businesses, limited recourse borrowing arrangements (LRBA) have become critical to their retirement income strategies. The need to reinvest in their businesses often limits their superannuation contributions so a strategy that affords them the opportunity to transfer their business premises into their SMSFs can provide a handy nest egg in retirement.
The benefits of adopting this strategy are self-evident: guaranteed rental income, giving small business owners access to superannuation tax benefits and allowing more flexibility in relation to ownership structure and succession planning.
For these reasons alone LRBAs should be an accepted part of the credit landscape. Yet they are never far from the headlines, with the Council of Financial Regulators providing a recent one when its report on LRBAs cast another cloud over this debt instrument.
No one questions the proposition that LRBAs have been misused sometimes and certainly not the SMSF Association. The unscrupulous provision of LRBA and SMSF advice via one-stop property shops has been a blight on the sector; the unwary have been preyed upon to use this form of debt to access the property market.
The regulators have been right in trying to stamp out this unscrupulous behaviour, with ASIC’s “Report 575 SMSFs: Improving the quality of advice and member experiences” highlighting the issue. For the association’s part we suggested two measures in our submission to the Council of Financial Regulators we believe would help curtail the exploitation of the naïve investor: prohibiting personal guarantees and improving specific SMSF education about LRBAs.
Personal guarantees allow SMSFs to undertake larger borrowings with higher loan-to-value ratios (LVR). Lenders would need proof positive the SMSF could adequately service the loan based on the financial circumstances of the fund’s members instead of relying on assets and income outside of it. And improving adviser and consumer knowledge about LRBAs, the risks as well as the positives, speaks for itself.
But to acknowledge there are problems with LRBAs is not to argue for their abolition. Instead it’s a clarion call to address the risks because all the evidence shows any misuse of LRBAs does not add up to a systemic risk to either the SMSF sector or the broader superannuation system. To this point the numbers are compelling.
At 30 December 2018, the latest ATO statistics have LRBAs at $42.8 billion, making up 6.1 per cent of all SMSF assets ($696 billion). Over the four years from December 2014, this is an increase in LRBAs of 161 per cent from $16.4 million at 31 December 2014 and, on the face of it, represents exponential growth over this period. But dig deeper into the figures and a different picture emerges. In the June quarter 2017, LRBA lending jumped a massive 37 per cent from $30 billion to $41.1 billion. But in the succeeding six quarters, from June 2017 to December 2018, they only rose 4.1 per cent to $42.8 billion. Quite clearly LRBAs have lost their lustre and two reasons seem to stand out.
Firstly, residential property has had a fall from grace and this asset class typically absorbed about half of all LRBAs. Although this market, especially in the major capital cities, appears to be bottoming out, many investors who were queuing up at auctions are remaining on the sidelines. Secondly, many lenders are leaving this market, notably the big four banks and AMP, having decided they are not worth the effort. In both instances the market has provided the solution.
There is another point worth considering. SMSFs largely use LRBAs in the accumulation phase. Once retirement beckons most clearly decide not to have any debt in their portfolios, with December 2017 Class benchmark data showing only 1.3 per cent of the SMSFs on this administrator’s books have a property-related LRBA in the retirement phase compared with 10.9 per cent in the accumulation phase.
Before the association made its submission to the Council of Financial Regulators, it decided to survey its professional members about LRBAs. The 158 responses demonstrated a strong consensus that LRBAs can be a suitable strategy for building retirement savings, especially as it relates to real business assets. Interestingly too the responses reflected a more conservative approach to this credit instrument, with many agreeing policy safeguards should be considered.
Our members are at the coalface working with SMEs to devise suitable retirement income strategies. They know, better than most, how small business owners can use an LRBA to achieve financial security. Not only are they specialists in this field, but their clients regularly make commercial and investment decisions. So to remove their access to an LRBA after getting professional advice would remove an attractive retirement income strategy for many SMEs.