Does your SMSF investment strategy have any metrics?

Since August 2012, the content and intent of the investment strategy for an SMSF has become an operating standard and subject to audit scrutiny. Additionally, since 1 July 2015, a breach of these standards could also result in an administrative penalty of up to $900 per trustee personally.

This requires SMSF trustees “to formulate, regularly review and give effect to” their investment strategy. If we look at these elements, we see that the first and third have to be closely linked, as the third is really a measure of whether or not we are following the strategy and obtaining the outcomes expected. If we are not following the strategy, then clearly we will not obtain those objectives.

So what are the objectives we are looking for in an investment strategy? This is where the great variance in the substance of investment strategy statements for SMSFs occurs. We can see statements such as “the objective is to provide sufficient assets to allow me to retire in a style that I wish”. The question is: as a trustee, how do I know along the way whether or not this “objective” can be met?

It is because of this question that we believe it is necessary to have clearly defined measurable and objective factors as part of an investment strategy to determine its success.

So what are the considerations for an investment strategy that can be measured?

If we look at the provisions under Section 52B(f) of the Superannuation Industry (Supervision) Act 1993, we see there are four main limbs with key determinants:

1. 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;
2. The compositions of the fund’s investments as a whole, including the extent to which the investments are diverse or involve the fund being exposed to risks from inadequate DIVERSIFICATION;
3. The LIQUIDITY of the fund’s investments, having regard to its expected CASH FLOW requirements;
4. The ability of the fund to discharge its existing and prospective LIABILITIES.

So how do we quantify these determinants?

Risk is an issue. Do we mean risk of capital or volatility of return or both? To quantify potential loss of capital, it is not unusual to consider the frequency of potential capital loss in a given period but this does need to be considered with the question of volatility of the loss, as two slight losses over a 10-year period may be acceptable compared to one major loss in the same duration. This volatility is quite often picked up as part of the return benchmarks, which usually have two elements: one, a peer benchmark that would reflect some of the volatility, such as performance or outperformance of an asset class index (e.g. ASX200). And the other would be a margin over a cost index, such as 2% above CPI. These types of measurements can then be compared with the actual investment performance as a measure to determine if the outcomes are as expected. One critical element is the time duration for these measures and superannuation is a long-term environment. And when measuring returns, appropriate periods should be used. It should be noted that APRA normally expects superannuation funds to do performance calculations over five-year rolling periods.

Cash flow will need to take into account the likely movements of the SMSF as well as the timings. Cash inflows will come from two major sourcing, being income on the investments as well as capital contributions, such as contributions and rollovers. Outflows will be fewer in accumulation funds with investment and running expenses, insurance premiums plus tax being the main causes. In contrast, a pension fund will have more outflows due to the requirement to make pension payments and may also be unlikely to be receiving contributions. Thus will the timing of the inflows provide sufficient cash to meet each outflow as it occurs or will asset disposals be required?

Of course, one of the big myths with SMSFs is that they are only invested in Cash and Property but our experience is this is not really the case.

Nevertheless the question of diversification should be considered. So having asset allocation targets as well as ranges will help SMSF trustees review their exposure to each class, as well as decide whether adjustment is necessary.

Closely linked to the cash flow and diversification considerations is liquidity. In a sense they are the two sides of the equation. Cash flow is the result and the asset allocation will impact on the likelihood of the SMSF having sufficient cash to meet its needs.

Of course, different asset classes will produce income and cash with different timings. Interest can be produced on a range of frequencies from daily through to annual or on maturity. Equities generally only produce income every six months via dividends and property most likely on a weekly, fortnightly or monthly basis from rental.

Of course, if the income produced is not sufficient then the ability to divest assets into cash will become important. If there is a large asset due to reduced diversification, which particularly is an issue with real property, the inability to dispose of quickly or even partially can be material.

An SMSF is ultimately a superannuation fund and its primary purpose is to be able to pay benefits, which are its liabilities to its members. The ability to pay out a superannuation benefit to a member, be it a lump sum or a pension payment will be an interaction of what cash is required as well as the ease if necessary to convert an investment into cash.

How often should we review the investment strategy?

The last obligation for an investment strategy is to “regularly review” the strategy. So what does this mean? Due to the annual audit process, at least once a year how the SMSF is invested should be compared with the strategy to see if it is in accord. This should not be the only time that the investment strategy is reviewed; other events should also act as triggers as they will have impact on the key determinants. Some of these events and the affected determinants would be:

1. Adding a new member. This could impact the cash flow with further contributions, insurance premiums and tax liabilities. It may also affect the level of diversification and risk and return for the SMSF, if the new member’s tolerances are different to the existing members,
2. Starting a pension. This would result in a change to the treatment of liabilities as benefits would become immediately payable as well as increasing the need for liquidity to meet the cash flow of the pension payments.
3. Implementing a borrowing arrangement. This would result in a new liability for the SMSF with the loan needing to be extinguished prior to the disposal of the asset acquired. Of course, liquidity is needed to service the loan, which could put a further drain on the existing cash flow; and
4. Acquiring a property or of large value asset. This may result in changes to the diversification of the investments as well as liquidity particularly if the asset is one that cannot be quickly sold or easily partially sold.

While having metrics in an investment strategy will not solve all the concerns about how an SMSF is invested, having quantified and measurable targets for comparison will provide a beneficial tool to help trustees reach the intended goals.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.