Why Low Balance SMSFs Still Trump the Big Funds

There’s been a lot of negative press lately about so-called low balance Self Managed Superannuation Funds (SMSFs).  Does that sound familiar?  It really wasn’t that long ago that ASIC was echoing the calls from the big public offer retail super funds to have a go at the humble SMSF by issuing two information sheets, ostensibly to improve the quality of advice provided by advisers on self managed superannuation funds, namely:

• Information Sheet 205 Advice on self-managed superannuation funds: Disclosure of risks (INFO 205); and
• Information Sheet 206 Advice on self-managed superannuation funds: Disclosure of costs (INFO 206).

The bottom line of these information sheets was to bag the "cost-effectiveness" of an SMSF, and make clear ASIC's view that an SMSF with a starting balance of $200,000 or below is unlikely to be in the client’s best interests and that advice to establish one below that threshold is more likely to be scrutinised by ASIC.

Now it’s all happening again, this time with the Productivity Commission’s report on the efficiency and competitiveness of the superannuation system released on 29 May 2018 finding that SMSFs with less than $1 million are "not competitive" against retail super offerings!!!

The problem with all this public flagellation of SMSFs based on comparing their returns with those of the players at the big end of town is that it all entirely misses the real point – and that is that having an SMSF is NOT all about investment returns.  In fact, especially from an estate planning viewpoint, there are compelling reasons why an SMSF (irrespective of fund balance) will always "trump" a big public offer retail super fund EVERY TIME.

Why "Low Balance" SMSFs Still Trump the Big Funds

According to the Productivity Commission, more than one million members have chosen to self-manage their super in an SMSF.  Large SMSFs are broadly competitive with institutional funds in terms of net returns. However, smaller ones (with less than $1 million in assets) perform significantly worse than institutional funds, mainly due to the materially higher average costs they incur due to being small (page 14, Superannuation: Efficiency and Competitiveness Draft Report).

It goes on to say that reported costs for SMSFs have increased over recent years and, for those with over $1 million in assets, are broadly comparable with APRA-regulated funds as a percentage of member account balances.  By contrast, costs for low-balance SMSFs are particularly high, and significantly more so than APRA-regulated funds.  These high costs are the primary cause of the poor net returns experienced by small SMSFs on average (Draft Finding 3.3).

Well, we’d suggest that to call an SMSF with a balance of $999,999 a "low balance" fund is a bit on the nose – even ASIC in its latest report released on 28 June 2018, Report 575: SMSFs: Improving the quality of advice and member experiences, still aimed its criticisms at SMSFs with a balance of $200,000 or below.  It really smacks of lobbying against SMSFs by the big end of the industry, doesn’t it?

Well there’s really at least three areas in which an SMSF is always going to trump a big public offer retail super fund, namely: 

1.       Control:

The big public offer retail super funds have very selective memories, don’t they?  Remember before the recent boom conditions when it seemed that you could always rely on your average public offer retail super fund to post a negative return (taking into account the fact that the major proportion of the "income" earned on your account was really just you putting more money in as SGC??), particularly in the last 10 years since 2008?  For example, in the Australian Prudential Regulation Authority (APRA) report on the performance of Australia’s largest 200 superannuation funds for the years 2004 to 2013, it was noted that for the 5-year period up to 30 June 2013 (financial years 2009 to 2013), the 5-year average across all entities was only 3.9% each year.  And these are Australia’s largest 200 superannuation funds.

That was when a lot of superfund members got to thinking, well if I have to put money into super because it’s compulsory, then I may as well be losing the money myself instead of paying someone else to lose it for me! Hence Australia witnessed a surge in SMSF establishments so that as at 30 June 2017, according to statistics released by APRA and the Australian Taxation Office (ATO), close to 600,000 SMSFs were in operation, managing $696.7 billion in assets - nearly a third of the $2.3 trillion or so invested via Australian superannuation funds - with thousands of new SMSFs being established every quarter.

No wonder the big end of town was and remains worried!

And control over investments is not the only autonomy attractive to SMSF-ers.  There’s control over how the fund is administered and by whom, control over the release of funds (ever noticed how slow public offer funds are to release money especially when the member is rolling over to another fund) and finally there’s the peace of mind from knowing that your super is not being held by some outfit whose agenda is purely and simply to make money out of you and who may or may not be doing the right thing, now or in the future. 

2.       Unique investment opportunities:

Show me a big public offer retail super fund which will let you do any of the following:

(a)    Buy residential real estate

SMSFs have been unfairly picked on for supposedly gorging themselves on homes in first home buyer territory to the detriment of first home buyers (in fact, according to the ATO, only 4% of SMSFs’ total assets are invested in residential property).

But the reality is that residential real estate has (for everyone out there who timed it right, not just SMSFs) been an outstanding investment for SMSF members – and in many cases SMSFs have generated far better returns than the big retail funds whose only options for members is to just stick their money into ubiquitous (and commission paying, and often vertically integrated) managed funds.

(b)   Buy your business real property from you

Can anyone seriously claim that someone who set up an SMSF to buy their business real property from them (perhaps a commercial strata unit worth a "mere" $500,000), is running their business from it and paying (and claiming a tax deduction at maybe 45% for) market rent to their own superfund taxed at only 15%, with the prospect of retiring one day and selling the unit in pension phase capital gains tax free, regrets not having stuck their hard earned dollars into a big retail fund instead?

We’d really love to see an Industry Super Funds "Compare the Pair" TV ad example on that one!!!

(c)    Let you borrow to do either (or both) of the above

Now here’s the rub – just because you might not have a whole lot of money to start up your SMSF with doesn’t mean you can’t buy that residential property or business real property, because you can borrow money – including from a related party – to buy it under a Limited
Recourse Borrowing Arrangement.

So looking again at the business real property example above, let’s now factor in that the member’s own family trust lent the money to the fund (at market rates of interest and on full commercial terms) to do the deal.  On top of the advantages already mentioned, now add:

(i)      market rates of interest being paid to a discretionary family trust with the interest being claimed as a tax deduction for the fund and the family trust distributing the interest income tax effectively – and if the trust happens to be a discretionary testamentary trust, that interest can be allocated to minor beneficiaries completely tax free up to the adult tax free threshold; and

(ii)    the benefits of LEVERAGE to MULTIPLY the earnings per dollar actually invested by the member – so a 3% return gross on a maximum 70% LVR means a real return per dollar invested of 10%!!! Much, much better than what the top 200 Australian superannuation funds were averaging for the years 2004 to 2013.

Clearly there is no comparison here between "low balance" SMSFs and the big public offer retail super funds when you factor in all the unique abilities of SMSFs to invest member’s funds – the "low balance" SMSFs win hands down!

3.       Estate planning flexibility:

However, now we come to the crux of the matter.  As they say, death is one of the certainties in life, and whilst the sole purpose of a superannuation fund is the provision of retirement benefits in most cases there is likely to be something left over when the fund member dies – in some instances (especially where life insurance is taken out via super) quite a substantial sum of money, and perhaps well over $1 million at that.

Given that a superannuation fund (SMSF or otherwise) at law could ultimately be a discretionary trust because the fund trustee has a discretion regarding to whom to pay a death benefit (amongst so-called “SIS dependants”), PLUS given the fact that on the death of a member that death benefit may be pretty large (and in the case of young people who die before having the opportunity to build significant wealth in their own names, quite possibly that death benefit is THE most significant part of their “wealth” – as it was in the case of McIntosh v McIntosh [2014] QSC 99 where the net assets of the deceased were about $80,000 but his interests in various super funds totalled approximately $454,000)) it is absolutely imperative that a fund member make a Binding Death Benefit Nomination (BDBN) to direct the trustee of the fund regarding how and to whom to pay their death benefits.

Unfortunately this is where the big public offer retail super funds are sorely lacking.  Most only offer members the ability to make a BDBN with a single level of nomination (so you can nominate one or more persons and / or your estate in varying amounts, but you cannot nominate a further level of beneficiaries if none of the persons at the primary level are able to accept payment) and with a three year expiry date – so that if you don’t remember to renew the BDBN within the three year period, the nomination lapses and the trustee’s discretion rules again.

In fact, dying without a valid BDBN can be actually worse than dying without a valid Will – at least if you die intestate, the State or Territory laws provide for a statutory order of persons to whom your personal estate will go to when you die.  Not so with super – the fund trustee has an absolute discretion regarding to whom to pay your death benefits – even all to themselves against the member’s express wishes (see the classic case of Katz v Grossman [2005] NSWSC 934 for a wonderful example of this!).

In recent years, some public offer retail super funds have been offering a Non-lapsing BDBN, but that’s about the most you can hope for from these funds.

Whereas with an SMSF, you can have much greater flexibility, subject only to the terms of the relevant fund trust deed and the requirements of SIS law as regards to whom and how the benefits may be paid.

This ability is particularly important for fund members who are in a "blended family", where the restrictions of a public offer retail super fund are completely inappropriate.

For example, suppose Marge is a widow with three adult children, Bart, Lisa and Maggie.  She meets Daffy, a widower with three adult children Huey, Luey and Duey.  Marge and Daffy hit it off and get married.  Neither of them has a lot of money.  Each of them has around $400,000 in super, and they pooled their other assets together to buy a modest house to live in as tenants in common in equal shares.  Their estate planning objective is to look after each other in terms of somewhere for the survivor of them to live and something to live on, then when the survivor of them dies their respective assets are to go to their own respective children.

That means under their Wills they will give each other a right to live in the deceased’s half of the home until the survivor of them dies, whereupon the deceased’s half of the home goes to their own children.  To support the survivor during their life, they want to give each other a lifetime pension from their super death benefits (because there isn’t enough in their personal estates), and then on the death of the survivor of them the death benefits are to go back to the children of the deceased fund member – or failing that, to the fund member’s estate for the benefit of their grandchildren.

There is NO WAY that a public offer retail super fund will allow Marge and Daffy to make a Non-lapsing BDBN that will achieve all those ends. This strategy is ONLY possible with an SMSF with an appropriately worded trust deed (such as a SUPERCentral SMSF trust deed).

Call to action!

However, the big public offer retail super funds don’t care about any of this.  They just want to shut down SMSFs in reliance on these flawed "reports" by bodies such as ASIC and the Productivity Commission who have limited understanding of the potential financial and estate planning choices available in the real world.  The goal of the retail super sector is to force people to put their hard-earned compulsory super contributions (eventually increasing to 12% of your gross salary) into their funds where the trustees will "invest" the monies into vertically integrated managed funds designed to keep this gravy train chugging along for perpetuity (and by the way, superfunds have NO perpetuity period so they really CAN go on FOREVER).

So let’s all support all lobbying efforts by organisations such as the SMSF Association and the like to stop the big end of town from destroying the nest eggs of SMSF members in order to feather their own!!!

For more information about the above article, please contact:

Brian Hor
Special Counsel – Estate Planning & Superannuation
brian@townsendslaw.com.au

Peter Townsend
Principal
peter@townsendslaw.com.au