DIY fund critics don't add up

The DIY scare campaigns are rubbish … and they’re cheaper to run than balanced funds.

PORTFOLIO POINT: As well as providing greater investment flexibility, self-managed funds on average cost less to operate than balanced funds.

Regularly in the personal wealth sections of our daily newspapers there are “scare” articles, with the tax department warning trustees of self-managed funds that the rules are getting tougher.

All sorts of penalties are paraded before the self-managed fund trustees trying to convince them that they are better to stay with the big institutions rather than have their own fund.

It’s absolute rubbish. In most cases you will do better with a self-managed fund and if you obey basic self-managed funds rules you will not get into trouble with the tax department.

Last week I described how I recommended a self-managed fund to a retired friend who had been butchered in the balanced fund game. I also quoted some figures as to what is might cost him to start and run a self-managed fund. Today I want to talk about how to avoid the sort of practices that might put you on the wrong side of the Tax Commissioner and to look more closely at what it costs, or should cost, to run a self-managed fund.

I have two self-managed funds and my first rule of thumb is not to allow either of the funds to have a business relationship with me. That means they don’t own my holiday house, and they don’t transact with me in any way that would affect their ability to fund my retirement.

I realise that many people use their self-managed funds to own a factory or warehouse and there are other business relationship with their funds. Other funds borrow to buy property. Whenever you do this, you must seek expert accounting and perhaps legal advice. It can be done but great care must be taken because that’s where the dangers are. My funds have written investment strategies, but they are very much motherhood documents and everything that is done is aimed at benefiting my retirement.

Of course, you do have to keep good sets of accounts but, if your fund is simple, that is not hard – the banks do most of the work.

If you are extracting a pension and the fund is therefore in pension mode and not paying tax on its income, then you must calculate that pension correctly. Your accountant will normally hire an actuary to do it for you. It’s not expensive – usually about $500 to start up.

These are fairly straight-forward rules which are not hard for most people to undertake, and there is plenty of advice around if you need extra help – and unless you have a complex problem it’s not costly.

When it comes to fees, the level of fee charging will depend on how complex your fund is and how many transactions you undertake each year. If you have a complex fund that is trading in and out of securities then, of course, the costs in running that fund will be much larger, but if you have a simple vanilla fund then the costs are not high.

I asked Eureka Report chief reporter Caleb Samson to do some extra work on this subject. This is what he came up with.

The Australian Taxation Office provides some very general statistics on the costs of running an SMSF, as well as the median and mean audit fees to expect. On raw average, the ATO found the 2010 average total expense to be $4,840, which is very high for simple funds. It indicates that many people use their funds to trade securities.

But a more revealing story comes from percentages. According to the ATO data, in 2008, 44% of SMSFs paid less than 0.5% in operating expenses. But self-managed funds are getting smarter, so in 2010 49.7% kept their operating expenses below 0.5%.

Remember that if you are not very careful, balanced fund charges can go above 1.5%. In 2010, 81.3% of SMSFs paid less than 2% in total operating expenses and 74.6% of self-managed funds paid less than 1.5%. That means the overwhelming majority of self-managed funds, in spite of the numerous possible extra complications and expenses, still cost less than the standard, more restrictive, balanced funds. This graph tells the story.

It’s clear that the number of SMSFs with costs in the lowest band is rising each year, and costs for all but those most expensive funds are reducing each year

The fees for the SMSF audit component were $609 per fund on average, and just $490 for the median fund. The ATO found both of these figures were higher for funds where the auditor provided other services, and about 5-6% lower for just the audit.

Kathy Evans, superannuation and SMSF principal with accountants WHK Group’s Albury office, notes that each year a fund needs to have set of financial statements and an annual return prepared. They also need to be audited every year.

“Then depending on whether there’s pensions in the fund you may have actuarial fees, and there may be costs associated with setting up or changing the pension.”

Evans says the cost of operating a ‘vanilla’ fund, where investments are confined to term deposits, index fund, bank hybrids and cash and there are not a lot of transactions, is somewhere between $1,200 and $1,500 for the administration, plus the audit.”

That means the most basic fund could be run for under $1,700, possibly less, depending on how confident the investor is to manage some of the paperwork themselves.

I think Kathy Evans’ figures are probably about average, but if you work with your accountant and agree to do the simple books then costs can be lower. As I explained last week, I was able to negotiate a price of $1,000 a year, including audit (but not pension calculation), for a fund confined to term deposits, cash and one equity investment (listed investment company or indexed fund). There would be no transactions except monthly term deposit income and monthly automatic pension payments, investment company dividends and term deposit rollovers.

On start-ups, Evans explains the basic expenses: “You need to get a trust deed … and if you have a corporate trustee then you have the cost of the set-up of the company. Then you have a service fee for the general set-up of the fund with the ATO and whatever’s required for its registration”.

On my sums with a simple fund, a husband and wife or family can be the trustees so establishment costs can be confined to $2,000.

All this means that if you have $150,000 in the fund without a pension, then the cost of running a simple fund can be around 1%. That is not a high fee when compared to the costs that are levied by many balanced funds.

One of the reasons why people with self-managed funds often perform better than balanced funds is that they have access to bank term deposits. Australian banks are trying to lessen their dependence on overseas wholesale borrowing, so they are offering rates that are much higher than the Reserve bank’s cash rate. They represent very good value, especially given that they are guaranteed by the Commonwealth government as long as the deposits are less than $250,000. In other words, you are getting a government guaranteed security yielding around 5% for a five-year term deposit. That is a lot better than government bonds.

In terms of equity exposure, there are some excellent investment companies in Australia including the listed Australian Foundation Investment Company as well as Vanguard Index Funds. It is therefore possible to have an effective superannuation fund with very few transactions.

The important thing about self-managed funds is that if you don’t have expertise in share or other securities markets then don’t take risks and trade. Invest in interest-bearing securities where you know you are going to get your money back and spread your equity risks.

If there is ever any doubt about the desirability of self-managed funds it was ended with Alan Kohler’s dramatic piece this week (click here), which explained that those who had invested in balanced funds over a 15-year period had returned 4.9% and paid very high fees.

The balanced fund movement is going to have to take a very close look at itself. Already self-managed funds represent 35% of the market, and clearly it is going to go to 50% and even higher.

The balanced fund movement is going to have to get its costs much lower and tailor its products to the needs of investors. At the moment the self-managed fund enables investors to do this job very well.

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