The rules of investing and investment strategies

One of the major benefits of a self-managed superannuation fund (SMSF) is the flexibility given to trustees to directly invest in whatever they want, except for some restricted investments.

Some of the investment restrictions on trustees are:

• investments must be purchased and maintained at arms length,
• investments cannot be purchased from members and related parties except in limited cases,
• In-house assets cannot exceed 5 per cent of the market value of the fund, and
• investments must be purchased in accordance with the investment strategy of the fund.

This requirement to have an investment strategy comes from SIS regulation 4.09(2). That section states:

“The trustee of the entity must formulate and give effect to an investment strategy that has regard to all the circumstances of the entity, including in particular:

1. 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;
2. 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;
3. the liquidity of the entity's investments, having regard to its expected cash flow requirements;
4. the ability of the entity to discharge its existing and prospective liabilities”.

As a result of the Jeremy Cooper review into superannuation, changes were made to the Superannuation Industry (Supervision) Regulations.

Several of the changes directly related to the investment strategy for SMSFs. These were the requirement:

• for trustees to consider the need for insurance for the members as a part of the fund's investment strategy,
• to regularly review the investment strategy of an SMSF,
• for trustees to keep money and other assets of an SMSF separate from their personal investments, and
• for all SMSF assets to be valued at market value for reporting purposes.

This means in simple terms the SIS regulations now require that the trustees of an SMSF must prepare an investment strategy at least annually that considers the following:

• Risk;
• Liquidity;
• Diversification; and
• The need for members to have insurance.

An investment strategy can be as detailed or as summarised as the trustees want, as long as it meets the SIS regulations and is acceptable to the ATO. On the ATO website, in the publication titled, “Guide to self-managed superannuation funds”, the ATO provides the following guidance for trustees when preparing their strategy.

The ATO states that trustees need to consider:

• diversification (investing in a range of assets and asset classes)
• the risk and likely return from investments, to maximise member returns
• the liquidity of fund's assets (how easily they can be converted to cash to meet fund expenses)
• the fund's ability to pay benefits when members retire and other costs the fund incurs
• the members' needs and circumstances (for example, their age and retirement needs).

Other than these guidelines there is nothing specifically laid down as to how the investment strategy should be drawn up. An investment strategy can be as broad as the trustees want or state expected income yields, set percentages for the various asset classes, and even mention specific investments.

Before documenting the investment strategy for your fund a check should be made of the trust deed of the fund just in case it specifies a form and content that must be followed.

In some cases where an SMSF has one major investment, such as a property, an investment strategy should be formulated that deals with the problems associated with this investment approach. The strategy would need to state that the trustees have considered the risk of having one major asset, the problems with liquidity, and the lack of diversification. The strategy would also need to state how these problems will be dealt with going forward.

Because of the requirement for trustees to consider the insurance needs of SMSF members the investment strategy of the fund must show how they have dealt with this. Where the members have decided that the cost of insurance is too prohibitive the trustees, like industry and public offer funds, can have their members sign a form stating they will not take out insurance within the SMSF.

Insurance for SMSF members

Life Insurance

The amount of insurance a person needs is based on two main components. The first amount should pay off any loans of the deceased and their family. The second is the lump sum required to ensure that sufficient income is produced for the dependents of the deceased. 

As a general rule the greater the value of loans a person has, the higher the income they are earning, and the younger they are, the greater the amount of life insurance that needs to be taken out. As a person gets older, and their investments including super increase in value, the less they need.

For an example of how an insurance calculation is done click here.

Income protection insurance

The rules that apply to how much life insurance a person needs also apply to the other types of insurance that should be considered for SMSF members. The younger a person is, the more income they are earning, and the more money they owe, the higher the monthly amount of income protection insurance they need.

Many people do not take out income protection insurance believing that in the event of something happening at work they will be covered by the workers compensation insurance system.

Given that the quality of most people's lives is dictated by their ability to earn income, and there can be many accidents and sicknesses that have nothing to do with work, not having income protection insurance when it can be afforded does not make sense.

In some cases income protection insurance can be taken out through industry or commercial super funds at very cheap premiums. The problem is that many income protection policies in superannuation funds only pay benefits for up to two or three years

The main reason for taking out insurance is to cover you in the event of something drastically impacting your ability to earn income for the long-term. It is for this reason that income protection insurance outside of superannuation in many cases will pay a benefit to the insured until age 65.

Although income protection insurance may be more costly outside of superannuation, after taking into account that premiums paid for this type of insurance are tax-deductible, there can sometimes be little difference between the actual after-tax cost of income protection inside and outside of super. Of course if income protection insurance is not affordable having it in superannuation is better than not having it at all.

Total and Permanent Disability Insurance

The final type of insurance that should be considered for members of an SMSF is Total and Permanent Disability insurance. This insurance is meant to provide a lump sum in the event of a person becoming permanently disabled so that loans can be paid off, changes made to a person's home to make it more liveable, and also produce a lump sum to assist in producing an income for the insured and their family.

Even if the calculations show that some insurance should be taken out there are often good reasons why this would not be done within an SMSF. One of the main reasons could be that the cost is too high and earnings of the SMSF would be eroded. The other could be that insurance through an industry fund can be taken out and therefore is not needed in the SMSF.

Whatever decision is made the trustees of an SMSF must document the process and decision in some way.

Insurance Calculation Example

George 40 and Myrtle 35 have two children. George has calculated that the family needs $80,000 a year for their living expenses, but if they had to could live reasonable well on $50,000. George wants to calculate how much insurance the family will need until Myrtle turns 80 if he died suddenly.