Four key mistakes that SMSF Trustees make when investing in property

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1 Four key mistakes that SMSF Trustees make when investing in property When you decide to have your own Self-Managed Superannuation Fund, (SMSF) you get a high level of control over the investment choices and its rewards. You also assume the responsibility to manage its risk. It is this risk management that makes a professional relationship with Sapience an invaluable part of your strategy. Many SMSF s today are established by family members to enable them to invest in individual property or business assets. The typical investment time line to allow for property appreciation is usually 10 years or greater. Here are 4 key issues that SMSF Trustees often forget to manage 1. What happens if an SMSF fund member dies or needs to claim a disability payment from the SMSF, before the investment asset has had a chance to grow in value? 2. How do the other fund members avoid being disadvantaged by being forced to sell the single investment asset before it has time to appreciate in value? 3. Whose responsibility is it to repay the non-recourse loan often used to gear for the property purchase. 4. What happens when a fire-sale of a single investment asset doesn t return sufficient money to payout a debt and absorbs the other members super entitlements? Every SMSF is required to have an investment plan that matches the fund member s needs. Every SMSF is required to address liquidity issues in case a fund member needs to make a claim through disability or death from the SMSF. Lumpy assets Most commercially managed super funds use a range of investments to help spread their investment risk through diversification. Some SMSF choose to invest solely or predominantly in a single asset such as a property or a business asset. This is said to make the investment assets lumpy or ill-liquid. Traditionally shares and managed investment products can be quickly sold to produce cash whereas it usually takes much longer to sell a single high value asset. Relying upon a lumpy asset as an investment vehicle usually reduces the diversification options for the SMSF. So additional measures need to be put in place so that fund members are not Real World Full Picture Financial Advice

2 disadvantaged by the reduction in liquidity. Liquidity Liquidly risk occurs when investing in ill-liquid assets and where an unexpected benefit payment for one of the fund members, (either upon disability or death) risks not being met because of the lack of liquidity in the fund. If the majority of a SMSF s investment is locked up in a single or lumpy asset, this can have an immediate effect upon the SMSF s ability to meet its legal requirements in a timely manner, should a member who is entitled to a death or disability payment. If this claim for payment then forces a fire sale of a funds lumpy assets to meet the liquidity demands, this may in turn disadvantage the fund s investment plan. At the same time not being able to maintain liquid requirements for fund members risks a breach of the SIS Act and its Regulations. Solution? Lumpy assets in SMSF s pose a number of challenges. A simple and elegant solution to these problems is to use insurance to provide the requisite liquidity. This is called a liquidity strategy. How does it work? A Trustee of a fund can use insurance to generate a cash payment to the fund, upon the death or disability of a fund member. This means that a single or lumpy asset can be left to appreciate in value over time as originally planned, rather than forced into being liquidated early, to meet the claim. If a lumpy asset is expected to appreciate and potentially double in value over 5 years, than a Trustee might consider using insurance for those initial 5 years to remove the liquidity risk. Thus the level and length of time an insurance policy needs to be in place is different for each SMSF. When is the value of a fund members death benefit calculated The death benefit is calculated at the time of death, and is generally the deceased's member balance at death plus any life insurance that is paid on the member's death. When a fund member dies, the SMSF can either make a lump sum payment or commence an ongoing pension payment in accordance with the wishes of the member. The beneficiary must take the death benefit within a reasonable period, unless the benefit is being taken in pension form. The post death growth in value of the asset, generally cannot be split between the deceased and the survivors. It can be segregated in the funds accounting and used to fund a Real World Full Picture Financial Advice

3 pension payment to the deceased's nominated beneficiaries, if this was the wishes of the deceased member. This way the increased value of the lumpy assets can be utilised. This will not work if the members wish was for a death payment rather than a death pension to be established. The additional risk of a death claim upon a lumpy asset Without a liquidity strategy, these are some of the common problems that occur when an SMSF is forced to firesale a single or lumpy investment asset, before its expected maturity. There is a delay in making the death payment to the members estate. The members business interests may be prejudiced if it s a business asset to be fire-saled. Much lower values would be expected when selling is under pressure and the market becomes aware of a forcedsale opportunity. Early crystallisation of tax liabilities when an asset sale is forced during a SMSF growth phase. (CGT may not be payable when such an asset is sold in the pension phase rather than growth phase of the SMSF) A simple solution to liquidity risk issues when SMSF s invest in lumpy assets We generally suggest that SMSF s consider taking out liquidity insurance. This additional insurance cover providers the Trustee of the SMSF with an injection of liquid funds, at the time when it is most needed. This type of insurance is different from conventional life insurance in super. Traditional life insurance is owned by a specific fund member. Liquidity insurance is owned by the fund and all its members. This insurance is treated as an investment of the fund. The cost of this insurance is spread across all the members accounts balances pro rata and any proceeds from a claim are also shared across the members accounts in the same fashion. If the insurance policy is called upon, the proceeds of the claim boosts the net asset value of the SMSF and its cash reserves. This injection of cash is used to pay the deceased's entitlement to the net assets (including the lumpy asset) plus the deceased's interest in the proceeds of the insurance policy. The result The single or lumpy investment asset is left to mature in the SMSF and the remaining members continue to benefit from the asset and any future appreciation. The case study Peter, Paul and Mary operate a business. The business is run from a single commercial building that is held by PPM Super Fund, their SMSF. PPM Super Fund assets and liabilities before a liquidity strategy Factory premises $2,100,000 Cash $100,000 Liabilities Zero Real World Full Picture Financial Advice

4 Putting the liquidity strategy into place It was determined that $900,000 was required to be available as liquid funds to fund a potential claim from a member for death or disability. The Trustee established Life and TPD insurance to the value of $900,000 for each member of the SMSF. The member Peter dies and the Trustee is paid $900,000 by the life insurer. This benefit payment is added to the PPM SMSF assets and liabilities that are now: PPM Super Fund assets and liabilities after a liquidity strategy Factory premises $2,100,000 Cash $1,000,000 (ie: new $900K + existing $100K) Liabilities Zero $900,000 benefit allocated across each members account balance. Member total interest increases to $1,000,000. Peter s nominated beneficiary receives $1,000,000 funded from cash. Paul and Mary remain as members of SMSF owning the factory premises. How does this work for SMSF Trustees investing in property? Use insurance to extinguish limited recourse borrowings Life insurance policies can be taken out on the lives of the fund members to provide repayment of limited recourse mortgage debts upon death or disability of a member. This enables the SMSF Trustee to use the proceeds of an insurance claim to payout any limited recourse mortgage. This removes the debt from the SMSF and therefore increases the members account values while ensuring liquidity is maintained. Use insurance to preserve liquidity so that surviving fund members are not disadvantaged. Life insurance policies can be taken out on the lives of the fund members. This ensures that in the event of a death or disability claim, the SMSF s single or lumpy assets are not forced into a fire-sale to fund the claimants entitlement. It also prevents the surviving members from being disadvantaged by the funds decision to invest in single or lumpy investment assets. Can a SMSF pay for this type of insurance: Yes. Insurance provides the requisite liquidity required by Investment Strategy Requirements. (Regulation 4.09.) Premium expense must be allocated on a fair and reasonable basis. (Regulation 5.02). We generally suggest that liquidity insurance costs be prorated amongst all members accounts as all members benefit equally from the insurance cover. Action plan Engage your Sapience financial adviser to complete an Asset and Liability review to identify liquidity and debt protection risks that you may have missed Real World Full Picture Financial Advice

5 Together we can consider insurance and other liquidation strategies e.g. payment of benefits in pension form only. We will then formulate a proposal for consideration at the Trustee Meeting. You would then: o Hold the Trustee meeting and draft minutes. o Obtain the requisite insurance cover. o Allocate the premium cost in o accordance with the documentation. Ensure that insurance is properly disclosed in annual member statements. Review the insurance arrangement annually and update if necessary. If you know somebody who might be interested in this article please send them a copy. If you re the Trustee of an SMSF, or if your just a member, be aware of what and how the fund is investing your money. Investing in single lumpy assets carries special risks that are manageable with Liquidity Insurance. AUTHOR DREW BROWNE Sapience - with good advice, we give people choices Information current at: September 2013 Disclaimer: The information in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice that addresses your specific objectives, financial situation and needs before making investment decisions. While every care has been taken in the preparation of this information, Sapience Corporation Pty Limited does not guarantee the accuracy or completeness of the information. Sapience Corporation Pty Limited and Drew Browne, (AR & AR ) are authorised representatives of Pivotal Financial Advisers Limited. AFS License This document was produced in September Copyright Sapience Copyright Sapience Real World Full Picture Financial Advice Real World Full Picture Financial Advice

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