Setting up an SMSF Developing an Investment Strategy for your SMSF

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1 Setting up an SMSF Developing an Investment Strategy for your SMSF Australian Shareholders Association Tutorial Resource Library

2 Disclaimer The ASA is not licensed to give financial advice. The content of these presentations is not designed to provide any specific investment advice to any person present. The ASA does not accept any responsibility to inform you of any matter that subsequently comes to our notice that may affect any of the information discussed. Anyone wishing to act on any matter discussed should seek independent advice from a licensed financial adviser.

3 Outline This tutorial will cover the following topics: What the law says important legislation What the ATO says key points for SMSF trustees What does this mean interpretations and practical applications Components of an Investment Strategy How to prepare a strategy Through out the tutorial there will be examples provided to help trustees prepare an investment strategy.

4 What the Law Says The Superannuation Industry (Supervision) Act 1993 is the relevant act for SMSF trustees. All SMSF trustees are bound by this legislation in the way that they can operate their SMSF. Trustees are also bound by the SIS Act Regulations. The legislation is clear that there is a need for an investment strategy.

5 Key Points Note the key points in the following slide are the areas that must be addressed by an SMSF investment strategy, however trustees are not limited to this and can include other topics.

6 SIS Act [Superannuation Industry (Supervision) Act 1993] Section 52 B of the SIS Act, requires the Trustees to formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the entity. SIS Act Regulation 4.09, requires that the trustee of the entity must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to the following: the risk involved in making, holding and realising, and the likely return from, the entity's investments having regard to its objectives and its cash flow requirements; the composition of the entity's investments as a whole including the extent to which the investments are diverse or involve the entity in being exposed to risks from inadequate diversification; the liquidity of the entity's investments having regard to its expected cash flow requirements; the ability of the entity to discharge its existing and prospective liabilities; and For a self managed superannuation fund whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund

7 What the ATO Says The ATO has provided further clarification on some of the key points including stating that an investment strategy must be prepared and implemented.

8 Trustees Responsibility It is important for SMSF trustees to clearly understand that they are responsible for ensuring that their funds Investment Strategy is prepared and implemented in accordance with both the SIS legislation and regulations and the ATO requirements. The following 3 slides shows the ATO s view which is aligned with the legislation. It is worth reading as the language is easier to understand.

9 The ATO s view Trustees are required to prepare and implement an investment strategy. The strategy needs to reflect the purpose and circumstances of your fund and consider the following: Investing in a way to maximize member returns taking into account the risk associated with the investment Diversification and the benefits of investing across a number of asset classes (for example, shares, property and fixed deposit) in a long-term investment strategy The ability of your fund to pay benefits as members retire and papy other costs incurred by your fund Whether to hold insurance cover for one or more members of your SMSF The circumstances of members (for example, age, income level, employment pattern and retirement needs)

10 ATO s View What this means for SMSF trustees in practical terms is: An appropriate investment strategy will set out the investment objectives of the superannuation fund and detail the investment methods the superannuation fund will adopt to achieve these objectives. An investment strategy should be unique to the requirements of the fund and its members and should be reviewed regularly and updated as required. Trustees must ensure that all investment decisions are made in accordance with the investment strategy and should seek investment advice or appoint an investment manager in writing if in any doubt.

11 ATO s View Remember also that: The SIS Act provides a defense to trustees against an action for loss or damage suffered as a result of the trustee making an investment. This defense is available where the trustee can show that the investment was made in accordance with an investment strategy formulated under the investment strategy covenant [SISA s55(5)]. It is therefore recommended that the investment strategy be documented, such as in minutes, so that trustees can show that investment decisions are made in line with the investment strategy.

12 So What does all this Mean?

13 Auditors Role The fund s auditor must sign the audit report stating the fund has adopted its investment strategy so having a written strategy for the auditor to review makes sense. Also have regard to the SIS Act defense provisions.

14 Investment Strategy Templates Many trust deeds come with an investment strategy these are cut and paste templates and usually not detailed enough and certainly do not take into consideration an individual trustees particular circumstances. It is suggested that trustees need to prepare their own tailored and detailed strategy.

15 Different Strategies? Trustees need to sit down with the other trustees of the fund and work out what they want. If funds have members of different ages, risk profiles, etc it may be difficult to have only one strategy. If the fund needs more than one strategy then trustees need to segregate the assets.

16 Reserves Strategy? If a fund has reserves trustees probably need a separate strategy to manage these.

17 Components of a Strategy A good Investment Strategy should include: Purpose of the Fund Investment Objectives Investment Strategy Risk Diversification Liquidity & Liabilities Insurance Other

18 Purpose of the Fund The purpose is usually to provide both lump sum and pension retirement benefits for the members and in the event of the members death before retirement, to provide benefits for the dependants of the members. Note: The law states that the purpose of a fund with individual trustees can only be to provide pension benefits.

19 Investment Objectives First consider and document: The number, age and risk profile of the members. The retirement plans of each member: pensions or lump sum. Current and future liabilities of the fund including tax, expenses and pensions. Future member contributions.

20 Investment Objectives Then take into account: Fund s current investments. Members other assets. The need to segregate assets in the fund - eg members with different risk profiles.

21 Segregation & Minutes If trustees segregate the assets, then they can just have separate classes of members eg Class A and Class B and prepare an objective and strategy for each. The Trustee should document through relevant minutes that they have taken the circumstances of the fund into consideration when formulating the investment strategy.

22 Investment Objectives Formulate a General and/or Specific Objectives For example: To achieve a long term rate of return approximately equal to CPI. It is expected that year-on-year returns will vary little with a small probability of a negative return in any one year. To achieve cash related returns ensuring that the capital value of the fund is preserved at all times, so that a negative return is avoided.

23 Investment Strategy Identify the types of assets the fund will invest in and document this. For example: Investments shall be made in accordance with the Trust Deed and any overriding superannuation legislation. The fund s investments may include any investment considered prudent at the discretion of the Trustee.

24 Investment Strategy Example (cont.) Investments may include but not be limited to all or one of the following: direct equities, stocks, instalment and other investment-style warrants and derivatives and including participation in dividend reinvestment programs, rights issues, share participation and buy-back programs and the like; [Continue for other assets types.]

25 Investment Strategy Ranges Identify both a long-term (3-5 year) and short-term (usually 2 years or less) strategy. Outline the fund's target ranges (as a percentage) for each asset class it intends to invest in, based on the current or future asset allocation. A separate strategy needs to be set out for each class of members. Identify ranges for each asset class these can be indicative.

26 Investment Strategy This is an example of possible Asset Class Range table :

27 Risk Investment risk is borne by the members, as fluctuation in investment returns will affect the level of the members benefits on withdrawal. Detail each member s risk profile or one for the whole fund.

28 Risk Example For example: Class A members have a relatively long time horizon. These members are prepared to endure a reasonable level of volatility of returns in expectation of long term growth. The composition of the members is diverse and the collective risk tolerance indicates that there should be a balance of reasonable risk and volatility to achieve long term capital and income growth.

29 Risk vs Return The relationship between long term risk and return in the different classes also needs to be addressed. For example: Cash - Cash will generally be held in a cash management account (CMA) which is rated AAA and the trustee considers this to be reasonably risk-free. The CMA provides ready access to funds at a higher interest rate than an at-call savings account. The trust expects to achieve a return of approximately the 90 day bank bill rate less 1%.

30 Each Asset Class The relationship between long term risk and return needs to be documented for each asset class in the previous table.

31 Diversification Diversification is a general investment principal that states that spreading funds across a range of different investments helps to reduce risk and smooth investment returns. If the fund is not diversified, then the strategy needs to be explained in detail. The Trustee needs to outline various ways that diversification can be achieved, such as investing in different asset classes as opposed to one single type of asset.

32 Diversification Some examples: Diversification is achieved through a mix of investments across a range of asset classes. The Trustee recognises that diversification can result in significant reduction to return volatility while maintaining the level of anticipated return. Funds are primarily invested in equities and the Trustee recognises the higher risk and volatility of this strategy. Volatility will be compensated by the higher return and growth in the longer term. The shares are invested in different industries and sectors, which will spread risk to a satisfactory level. Funds are primarily invested in fixed interest and cash. This is suitable for the fund s policy of maximising capital preservation and avoiding a negative return.

33 Liquidity & Liabilities Issues to Consider and Document Cash for pension, taxation and other operational expenses. Reference should be made to short, medium and long-term needs.

34 Liquidity & Liabilities (cont) Trustees should consider and document the following where members assets are not individually segregated. Members ages and time horizon in the fund. Any anticipated benefit payment amounts over the next 1-5 years. If the fund s assets are not diversified eg one property, how that will be handled if a member wishes to exit the fund or dies and the remaining member(s) are not beneficiaries.

35 Insurance Trustees are also required to consider the suitability of the various types of personal insurances applicable to each member e.g. Life, permanent incapacity, trauma and income protection.

36 Insurance This should be done on an individual basis for each member with consideration as to whether the insurance would be more appropriately held in an individuals name (which may be the case with both trauma and income protection insurances).

37 Insurance The investment strategy should provide reasons for both the amount of insurance taken and/or why no insurance is considered appropriate. This does not mean that insurance must be taken in an SMSF but only that the trustees need to consider it.

38 Other Reserves Management Strategy A separate strategy (or strategies) needs to be detailed for reserves. On-Going Monitoring of the Investment Process Regulation 4.09 requires that the investment strategy be reviewed regularly. It is recommended that this be done at least annually or when there is a major asset purchase eg property, a change in membership of the fund or other major change eg commencement of pension phase for a member.

39 Acknowledgement The Australian Shareholders Association would like to thank member Jenni Eason for providing the material for this presentation

40 ASA Learning To find out about other learning resources available to investors, explore the ASA s Investor Education Pathway