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The importance of a properly formulated Investment Strategy


There are a number of provisions in the superannuation law (SIS  Act and SIS Regulations) as further outlined below pertaining to the obligation for an SMSF trustee to develop and give effect to an appropriate investment strategy which is consistent with the fund’s investment objectives and the retirement goals of members. This article will look at the requirements for a fund’s investment strategy, both at creation and ongoing, as well as what it can mean for a fund which does not satisfy these requirements.

Investment strategy covenant

Section 52B outlines eight (8) covenants that if not included in the governing rules of the fund, are taken to be so included. These covenants are extended to the directors of a company that acts as trustee of an SMSF1. Whilst a covenant is not defined in the legislation, it can be defined as:

“A clause of agreement contained in a deed whereby a party stipulates for the truth of certain facts, or binds himself to give something to another, or to do or not to do any act”.

Effectively, a covenant is an undertaking to do certain things. From the perspective of an SMSF the undertaking is given by the trustee(s) to the beneficiaries.

One of the section 52B eight covenants relates to Investment Strategy. Subsection 52B(2)(f) outlines the following covenant:

To formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the fund including, but not limited to, the following:

(i) the risk involved in making, holding and realising, and the likely return from, the fund’s investments, having regard to its objectives and its expected cash flow requirements;
(ii) the composition of the fund’s investments as a whole including the extent to which the investments are diverse or involve the fund in being exposed to risks from inadequate diversification;
(iii) the liquidity of the fund’s investments, having regard to its expected cash flow requirements;
(iv) the ability of the fund to discharge its existing and prospective liabilities;

There is no penalty if an SMSF trustee contravenes a covenant listed in subsection 52B(2). However, section 55 provides that where a trustee has contravened a covenant and a person suffers loss or damage as a consequence of that contravention, anyone involved in the contravention can be held liable for the loss or damaged suffered. You can refer to the case of Dunstone v Irving [2000] VSC 488 where the court ordered the continuing trustee of the SMSF to pay damages under section 55 to the departing trustee/member as compensation for a delay in transferring their entitlements to another superannuation fund. Whilst the members of the SMSF were business partners and this issue arose as consequence of one business partner’s departure from a construction and development business, disputes can also occur where the SMSF members are relatives which may cause a delay in transfer of a member’s entitlements held in the SMSF.

Investment strategy operating standard

Subsection 31(1) states that regulations may prescribe standards applicable to the operation of a superannuation fund, known as ‘operating standards’. The standards that may be prescribed are listed in subsection 31(2) and includes, in subsection 31(2)(l), standards relating to “the investment of assets of funds and the management of the investment”.

The regulations includes an operating standard relating to subsection 31(2)(l), being regulation 4.09. The primary requirement of this operating standard is outlined in subregulation 4.09(2), being:

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:

(a) the risk involved in making, holding and realising, and the likely return from, the entity’s investments, having regard to its objectives and expected cash flow requirements;
(b) the composition of the entity’s investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification;
(c) the liquidity of the entity’s investments, having regard to its expected cash flow requirements;
(d) the ability of the entity to discharge its existing and prospective liabilities;
(e) whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund.

The above considerations are similar to those included in the subsection 52B(2) covenants, however, the operating standard has the additional requirement for the trustees to consider whether or not to hold a contract of insurance that provides insurance cover for one or more members of the fund. The insurance requirement of the investment strategy is not a requirement for the SMSF trustee(s) to provide default insurance, it simply requires the SMSF trustee(s) to consider whether insurance cover should be provided for one or more members of the fund. These considerations would include:

  • whether a member has insurance;
  • if such insurance is held by the SMSF, in another fund or held outside superannuation; and
  • the type of insurance and level of cover.

A member may inform the SMSF trustee(s) that they do not require insurance, for example:

  • they are unable to obtain insurance due to age and/or medical reasons;
  • the cost of insurance is prohibitive;
  • they have sufficient assets to take care of dependants;
  • they do not wish the cost of insurance reducing their retirement savings.

A contravention of an operating standard may result in an SMSF administrative penalty being imposed of 20 penalty units. As of 1 July 2021 a penalty unit is worth $222, consequently, a total administrative penalty of $4,440 could be imposed, for each trustee of the SMSF, for a contravention of an operating standard from 1 July 2021.

Investment strategy trustee considerations

Whilst the investment strategy covenant and operating standard does not stipulate that it must be in writing, the ATO on their website states that an “SMSF investment strategy should be in writing”3. This will allow the SMSF’s auditor to review the investment strategy for compliance with the operating standard.

In accordance with the investment strategy operating standard, the investment strategy should have regard to the whole circumstances of the fund and address the considerations listed in subregulation 4.09(2). To achieve this, the investment strategy should be tailored and specific to the relevant circumstances of the SMSF, rather than a broadly worded template that would apply to a variety of different circumstances and simply refers to the legislation.

These points, as well as anything else included in the investment strategy should consider the relevant personal circumstances of each member. This would include, but is not limited to member, age, employment status, retirement needs and risk appetite.

It is not a requirement of the operating standard to have a stated asset allocation range. However, specifying appropriate allocations of percentages or dollar ranges for each class of asset ranges helps to show that the fund’s investment strategy has been given effect and is on track to meet the investment objectives. Where incorporating and determining the intended investment range of the various assets classes it is not enough for the range to be listed as 0 to 100%. This doesn’t show that there has been appropriate consideration of the member needs. However, if there is a need for broad investment ranges in order achieve the retirement goals of the members this needs to be explained and documented.

The ATO provides guidance on the preparation of an investment strategy for an SMSF. This guidance is available on the ATO’s website and can be found by either searching using the ATO Quick Code (QC) 23320 or by clicking here.

While the investment strategy is important and should help direct the fund’s decisions, it can’t override other superannuation laws. The development of the investment strategy should account for all factors which may impact the operation of the fund. This would include any restrictions resulting from the fund deed, specifically prohibited actions under superannuation law, as well as ensuring the sole purpose test is met.

Sole purpose test

The sole purpose test requires a fund to solely operate for the purpose of providing retirement phase benefits to the members, or their dependents if the member dies before retirement. There is likely to be a contravention of the test if a member or anyone else, directly or indirectly, obtains a financial benefit, external to the fund, from investment decisions and arrangements. If the fund provides a pre-retirement benefit to anyone there will also likely be a contravention. The sole purpose test must be met for the fund to be eligible for the tax concessions regularly available to superannuation funds.

As well as the loss of the tax concession, which for some funds will have an extremely large impact on the tax result, trustees could face civil and criminal penalties if there is a contravention. While we can see how important the sole purpose test is to the operation of the fund it does not mean that this is the only place where a fund could face legal issues if the investments are not properly considered. 

Diversification

Diversification refers to the spreading of the fund investments across different asset classes with the goal to minimize certain risks to the fund, such as return, volatility and liquidity risks. 

There are no set requirements for the diversification of investments in an SMSF, however, as the lack of diversification can expose the fund to increased risk it must be considered in the investment strategy. If a fund does invest predominantly in a single asset type, for example direct property, the investment strategy should document how the risks associated with the lack of diversity have been considered and how the investments still meet the fund objectives, i.e. return, cash flow, etc.

The section 52B covenants also include a covenant that requires the fund trustee(s) to perform their duties and exercise their powers in the best financial interests of all members. A lack of diversification could pose a potential legal risk for trustees of a multi-member fund as the asset/asset class that the fund has heavily invested in, may only be appropriate for certain members. Consequently, diversification or the lack thereof, should be considered as part of the formulation of the fund’s investment strategy and each time it is reviewed.

Further, the risks associated with a concentration of investment in a single asset is heightened where the fund has utilised borrowings, for example, property acquired via a limited recourse borrowing arrangement. Such a strategy can expose the fund members to a loss in the event the asset declines in value or where there is a forced sale as a consequence of a breach of the loan agreement terms.

Review

As both the circumstances of the SMSF members and the market will change over time it is expected that the investment strategy is subject to frequent review and updated as required to ensure it continues to meet the current and future needs of the fund members. The strategy should be reviewed at least annually, with the review and any decisions made from the review appropriately documented.

In addition to these regular reviews, it is expected that significant events would also result in an assessment of the investment strategy to determine if it still meets the fund investment objectives and the member’s retirement goals. Circumstances which may prompt a review could include, but are not limited to: 

  • Significant market events,
  • A new member joining or exiting the fund, 
  • A member commencing an income stream. To ensure the fund has sufficient liquid funds to meet the minimum pension payments, and
  • A significant investment in an asset/asset class, i.e. property.

A lack of frequent review leaves the fund at risk of having an investment strategy which is no longer suitable for the member’s needs and could result in a breach of the investment strategy.

Non-compliance with the investment strategy

As a part of the fund audit the auditor should check that the fund has an investment strategy in place that has considered all the appropriate factors (at least those listed in regulation 4.09), that the fund’s investments were in line with the strategy and the strategy has been reviewed during the financial year. If a breach of the investment strategy is identified the auditor may notify the ATO by lodging an auditor contravention report (ACR).

In most cases, when a fund auditor identifies that there has been a breach of the investment strategy the fund will be given an opportunity to address this before an ACR is lodged. The fund will be given a chance to attach a signed and dated addendum to the investment strategy or trustee minutes to address the issues identified. Any adjustments made should be shown to the auditor prior to the finalisation of the audit.

An auditor will lodge an ACR if they have identified that a breach from the previous year has been repeated in the current year or if a breach from the previous year has not been rectified. A report will also be lodged if a fund less than 15 months old has any single breach with a value over $2,000.00.

If an ACR is lodged with the ATO, the fund will be asked to rectify the breach if it has not already done so and an administrative penalty of 20 penalty units($4,440 for breaches from 1 July 2021) can be applied to each individual trustee or the corporate trustee.

While the penalty for non-compliance with the investment strategy may not appear overly onerous this can indicate a greater issue with the fund, like failing the sole purpose test, which as we have discussed, can have greater consequences. We’ve made comments above about the action that a person, who suffers loss or damage due to a SMSF trustee or other person contravening a covenant, can take and the case of Dunstone v Irving [2000] VSC 488. A recent relevant case is that of Merchant and Commissioner of Taxation [2021] AATA 915, an Administrative Appeals Tribunal (AAT) case.

The case concerned the application by two individuals, Gordon Merchant and Colette Paull against the ATO Commissioner’s decision to disqualify them from acting as trustees or responsible officers of a superannuation corporate trustee. Each applicant was the sole member of their respective SMSF. Both individuals were directors of the Gordon Merchant’s SMSF’s corporate trustee, GSM Superannuation Pty Ltd.

The ATO Commissioner initially disqualified the two individuals based on the view that GSM Superannuation Pty Ltd, in its capacity as trustee of the Gordon Merchant Superannuation Fund contravened:

  • Section 34(1) and regulation 4.09, because the trustee did not give effect to the investment strategy of the SMSF when it acquired 10,344,828 shares in Billabong International Ltd (a company listed on the Australian Stock Exchange at the time) from the trustee for the Merchant Family Trust on 2 September 2014;
  • Section 62(1) [the sole purpose test] because it maintained the SMSF for the collateral purpose of obtaining a tax benefit for the family trust and maintain confidence in Billabong International Ltd;
  • Section 65(1) SIS Act because it used the SMSF’s resources for a member of the fund or their relatives

Amended income tax assessments and penalty assessments were also issued to Mr Merchant; the trustee of the family trust and another related entity on the basis of application of Part IVA of the Income Tax Assessment Act 1936 (the general anti-avoidance provisions). An objection to such assessments were made by the respective taxpayers, which had not been decided upon at the time of the case.

The applicant requested that the decision to disqualify them be adjourned until after they had exhausted all legal avenues to contest the amended income tax assessments and penalty assessments. However, the AAT concluded “…that the interests of justice do not favour the granting of an adjournment of the Disqualification Review”. Consequently, the application for adjournment was refused and no consideration was given to the operation of the stay orders.

From an investment strategy perspective, it appears that whilst the SMSF was not prohibited from acquiring the shares from the related party, as they were listed securities and it is assumed that they were acquired at market value, the transaction was not in accordance with the SMSF’s formulated investment strategy. This highlights the requirement that it is not enough for a proposed transaction to meet the requirements of a specific provision of the superannuation law, in this case, section 66 t, but also to consider the transaction in light of the SMSF’s investment strategy. The case also implies that there was not sufficient evidence to show compliance with the sole purpose test and that there was evidence of a breach of section 65 SIS Act.

Consequently, when SMSF trustees are considering a proposed investment transaction, it would be prudent to ensure the proposed transaction:

  • is permitted under the SMSF’s trust deed;
  • is not prohibited under the SIS Act or Regulations, for example, for an acquisition of an asset from a related party it falls within one of the exceptions in section 66;
  • is in accordance with the fund’s investment strategy;
  • complies with the sole purpose test in section 62 and the trustees have sufficient appropriate audit evidence to substantiate such compliance.

It is also important to note that where an SMSF’s investment strategy is altered to accommodate a transaction and there is no substantiation of why the change was made, that would be a factor indicating that the SMSF is not complying with the sole purpose test5.

Multiple investment strategies

An SMSF trustee(s) can have/offer different investment strategies for different fund members or class of fund members6. This permits an SMSF to split assets into separate asset pools with their own investment strategy. The SMSF member can then provide direction to the trustee that specifies which strategy, or combination of strategies that the member has chosen. The member can alter their selected strategy at a subsequent date.

Reserves

One of the eight covenants applies to an SMSF that maintains reserves. The relevant covenant requires the SMSF trustee(s) to formulate, review regularly and give effect to a strategy for the prudential management of the reserve(s), consistent with the fund’s investment strategy and its capacity to discharge its liabilities as and when they fall due7.

An SMSF may maintain a reserve, for a particular purpose, unless the governing rules of the fund prohibit the maintenance of a reserve for that purpose8. However, reference should be made to the ATO’s views on the use of reserves by SMSFs in their SMSF Regulatory Bulletin (SMSF RB) 2018/1.

Who can prepare the Investment Strategy?

The investment strategy is to be prepared by the trustee(s) of the SMSF. If the trustee(s) require assistance with the preparation of the fund’s investment strategy, they should consider seeking advice from their SMSF adviser or licensed financial adviser.

Where advice is provided by an unlicensed accountant, care needs to be taken to ensure that the advice provided is for the sole purpose of ensuring compliance with the superannuation legislation and does not stray, providing advice that requires licensing. For example, an unlicensed accountant may provide advice on compliance with the investment strategy covenant (section 52B(2)(f)) and the related operating standard in regulation 4.09, but must ensure that such advice: 

  • is not about the acquisition or disposal by the SMSF of specific financial products or classes of financial product;
  • does not include a recommendation that a person acquire or dispose of a superannuation product;
  • does not include a recommendation about a person’s existing holding in a superannuation product, for the purpose of modifying an investment strategy or a contribution level.

The unlicensed accountant should also provide a written statement to the SMSF trustee(s) warning that: 

  • you are not licensed to provide financial product advice under the Corporations Act; and
  • they should consider taking advice from an AFS licensee before making a decision about a product.

Whilst an unlicensed accountant cannot provide advice to an SMSF trustee(s) about what their overall investment strategy should be, for example, what the target investment return should be and how to achieve it, a recommendation or statement of opinion on broad asset allocation within the SMSF can be provided9.

For further information on providing broad asset allocation and investment strategy advice refer to ASIC Information Sheet 216 (INFO 216) – AFS Licensing requirement for accountants who provide SMSF service.

CPA Australia and Chartered Accountants Australia and New Zealand have each published guidance for the accounting profession on the topic of Financial Advice and Regulations. In their respective Q & A section, they deal with the question “Can an accountant provide a pro forma generic investment strategy for a client with appropriate disclaimers?”.

The answer provided is as follows: 

Yes. An accountant can provide a generic investment strategy provided it falls within the broad asset allocation exemption in Regulation 7.1.33A.

However

The accountant must make it clear that the strategy is a generic template only, and it is up to the trustee to ensure it meets the relevant requirements. Also, the accountant should make it clear that provision of the template is not the endorsement of a particular investment strategy.

1.S.52C SIS Act
2.Mozley & Whiteley’s Law Dictionary (9th edition)
3.ATO website Quick Code (QC) 23320
4.Item 1 to table in S.166(1) SIS Act
5.SMSFR 2008/2
6.SIS regulation 4.02
7.S.52B(2)(g) SIS Act
8.S.115 SIS Act
9.Reg 7.1.33A Corporations Regulations 2001

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