ATO Investment Strategy | SMSF Investment Strategy

The ATO has initiated a review of SMSFs which hold 90% or more of the fund’s assets in a single class of investments.  Apparently, the ATO is using the 90% threshold as a means of identifying SMSFs which may have an inappropriate investment strategy.  Inappropriate in this context means lack of diversity.

Given this review should trustees of SMSFs which satisfy the 90% threshold, run around in a state of panic reprising Lance Corporal Jones from Dad’s Army?  In our view, no!

Investment Duty & SMSF Investment Strategy

The primary function of a superannuation fund – whether self managed or other – is to provide a capital amount to finance the member’s retirement.   Consequently, the trustees of a superannuation fund must invest the contributions with a view to providing this retirement capital.  Normally, trustees of superannuation funds are given wide investment powers to achieve this end.  However, the precise content of the duty to invest can be modified by the terms of the trust deed or even modified with the consent of the members of the fund. ATO Investment Strategy | SMSF Investment Strategy

In the context of a self managed superannuation fund, while the trustees may have very wide investment powers, the trustees could, with the consent and approval of the members, invest in only a single asset class.  This could be the case where the self managed superannuation fund is still growing to achieve an investible amount – in which case a purely cash or liquid assets strategy will most likely be appropriate.  Another situation is where the members have decided (because they are in effect the trustees) to invest in a single asset class or even in a single asset.  The obvious example would be a self managed superannuation fund being established to undertake an investment in real estate – whether geared by a limited recourse borrowing arrangement or not. 

What is the conclusion at general law as to a limited or even single asset investment strategy? 

The conclusion is that so long as the trustees have the power to invest to the asset class or classes constituting the limited or single asset investment, and the members’ consent to the limited or single asset investment strategy, there will be no breach of the general law duty of investment.

But what is the conclusion under the SIS Act and Regulations?

Starting with the SIS Act, there are three relevant provisions:  the investment strategy requirement of s52B(2)(f); the sole purpose test of s62A and the arm’s length investment requirement of s109.

The investment strategy requirement, when broken down into its elements, requires the trustees of a self managed superannuation fund to:

•    formulate
•    regularly review; and
•    give effect to,
an appropriate investment strategy.

The "formulation" requirement will be satisfied if the trustees document their investment strategy.  This entails the investment strategy being written down and adopted by the trustees.  Adoption is normally effected by way of a trustees’ resolution (preferably written with a copy of the written investment strategy attached to the resolution or, less preferably, by description of the particular document). 

Whether the "formulation" requirement has been satisfied can be readily determined: either there is a resolution approving the investment strategy or there is not.

The "regular review" requirement will be satisfied if the trustees reconsider the appropriateness of the current investment strategy either annually or when a significant event occurs in relation to the self managed superannuation fund.  Reviewing an investment strategy does not necessarily entail changing the investment strategy.  In particular, not changing an investment strategy every year is not proof that there has been no review of the strategy.  Who said you cannot not use a triple negative!

The trustees must, as part of the consideration of the annual financial statements, review the current investment strategy.  Additionally, the trustees should, by way of resolution, identify certain key events in relation to the superannuation fund, which if they occur should trigger a review of the current investment strategy.  The trigger events could include the death of a member, the commencement of a pension, the roll back of a pension, and the receipt of a material contributions or material benefit payment (material identified by dollar value or percentage of the current fund value). 

Satisfaction of the regular review requirement can be evidenced by trustees’ resolutions and, if trigger events have been identified, what action was taken by the trustees in response to the occurrence of the trigger event.

The “implementation” requirement will be satisfied if the investments of the superannuation fund comply with the adopted investment strategy.  Satisfaction of the implementation requirement would be confirmed by having no investments which are inconsistent with the current investment strategy. Or more positively, only having investments which are consistent with the current investment strategy.

An appropriate investment strategy?

The “appropriate strategy” requirement will be satisfied if the trustees, when formulating the investment strategy, have regard to the whole circumstances of the fund.  The “whole circumstances” of the fund include (but are not limited to) the following:

•    the risk/return of fund assets
•    diversification of fund assets
•    cash flow of the fund
•    solvency of the fund

The critical issues are whether:

•    the expression “have regard to” means “only have regard to”; and
•    the expression “whole circumstances of the fund” includes the circumstances of the members of the fund?

For the reasons set out below, the better view is that “have regard to” does not impose an exclusivity requirement and the “whole circumstances of the fund” include the circumstances of the individual members of the fund.

As to the exclusivity requirement – this is simply not justified by the express words of the statutory provision.  Further, there is no policy reason to impose an exclusivity requirement.

As to whether the individual circumstances of the members can be considered as constituting the circumstances of the fund – this is clearly justified as the fund has no circumstances apart from the individual circumstances of the members.  To illustrate the point, whether a member is likely to drawdown their benefits depends entirely on the individual circumstances of the member; merely because the member is eligible to drawdown their benefits does not mean that they will.  Whether a member who is eligible to drawdown their benefits will do so, depends on various circumstances which apply to the actual individual member (not some hypothetical member on the Clapham Omnibus engaging in wireless telegraphy.)

More relevantly, can the trustees have regard to the members’ superannuation interests in other funds or have regard to the members’ non-superannuation investments when formulating an appropriate investment strategy?  The answer is yes, as the trustees are not limited to only considering the four listed factors and the circumstances of the fund include the circumstances of the actual members of the fund.

The duty of the trustee is to have regard to the need for diversification, not that the investment strategy must be diversified.  Having regard to does not mean that a non-diversified investment strategy is necessarily an inappropriate investment strategy. (Almost another triple negative statement).

What is required is that the trustees consider the downside of investing in one asset or one asset class and for the trustees to have a documented response to the downside risk.  It could be that an investment strategy which consists of investing in a single asset, which has been acquired by a limited recourse borrowing arrangement, is appropriate as each member of the superannuation fund has superannuation interests in other funds or investments outside the superannuation regime, which provides sufficient diversification.  Alternatively, the trustee and the members could consider that an investment strategy which involves a single asset class or single asset will provide a better return over the long term.

If the trustees have documented the entire investment circumstances of each member and asset concentration risk has been counterbalanced by the investments outside the particular fund, then a single asset or single asset class strategy would be an appropriate strategy. 

Alternatively, if the trustees and the members of an SMSF have documented their consideration of the downside risk of asset concentration and have formed the view that the downside risk is more than matched by the expected performance of the single asset or single asset class strategy, then such a strategy would be appropriate for that SMSF.

What about the sole purpose test?

The sole purpose test set out in s62 of the SIS Act requires the trustees to maintain the fund solely for one or more specifically listed purposes (called core purposes) or, alternatively, for one or more core purposes and for one or more approved subsidiary purposes (called ancillary purposes).

The core and subsidiary purposes are to provide financial benefits in the event of specified contingent events – such as “retirement” or “attainment of a certain age” or “upon death”.

While the ATO continually tries to argue that the sole purpose test is really a “conduct unbecoming” provision – namely a provision which allows the ATO to simply proscribe any kind of activity it dislikes- the sole purpose test has a much more specific purpose.

If the trustees have adopted a non-diversified investment strategy – which is appropriate in the circumstances of the particular members of the fund – then the investment strategy could not be challenged as infringing the sole purpose test.

Arm’s length investing – s109

In simple and coarse terms, trustees must not invest if the investment is not on arm’s length terms or, if the investment is not on arm’s length terms, then those terms are favourable to the fund and not at the expense of the fund.

A non-diversified but appropriate investment strategy may or may not be on arm’s length terms.  Equally, a diversified investment strategy may or may not be on arm’s length terms.

Simply because an investment strategy is not diversified does not mean that the trustees’ implementation of that investment strategy necessarily contravenes the arm’s length investing provision.

SIS Regulation 4.09

This regulation was introduced to convert the investment strategy obligation into an operating standard and thereby permit the imposition of sanctions against the trustees if they fail to comply with the investment strategy duty. 

Also, it added another factor (which is not included in s52B(2)(f)) that the trustees have regard, when devising an appropriate investment strategy, to whether insurance cover should be held by the fund for the members.  This added on factor does not sit easily with an investment strategy – as insurance cover is really part of the benefit design of the fund and the cost of the premiums is merely an expense of the fund which is covered by either or both of the cash flow and solvency factors.  Consequently this additional factor is not currently relevant to the diversification or non-diversification controversy.

If the trustees have satisfied the investment strategy obligation then there will be no contravention of the operating standard set out in Regulation 4.09.

Bringing it all together and responding to Lance Corporal Jones

First, the ATO it not a licensed investment adviser.  Its officers are not qualified to pass a judgement on the investment strategy of an SMSF.

Secondly, despite the first comment, the ATO and its officers can assess whether an SMSF has adopted a particular investment strategy (because there may be no document in the possession of the trustees which has that title) and there may be resolutions or minutes to that effect.

Thirdly, the ATO can determine whether the trustees have implemented the adopted investment strategy.  This can be assessed by the mismatch between the asset classes of the adopted investment strategy and the actual investment classes of the investments portfolio.

To answer Lance Corporal Jones – rather than "don’t panic", ensure you have an investment strategy document which boldly and directly responds to the lack of diversification issue.  The bold and direct response could be by referring to the members other superannuation interests and their non-superannuation investments.  Alternatively the bold and direct response could be by reference to the fact that the downside risk of asset concentration are more than offset by the expected performance of the concentrated assets.