Eggs, baskets and diversified SMSF investment strategies

Through the course of this article, we will consider the ATO requirements of SMSF trustees, and the auditor of the fund, regarding the issue of diversification of fund investments.

Is “having all of your SMSF eggs in the one basket” permitted?

The short answer is, yes. There is no legislative prohibition on the nature or proportion of the investments an SMSF may hold, although there are some additional requirements imposed if the SMSF holds certain assets, such as:

• collectible and personal use assets,
• units in a related unit trust, and
• an investment made under a limited recourse borrowing arrangement.

While an SMSF trustee may hold virtually any investment available, there are legislative requirements concerning the formulation, and regular review, of the investment strategy of the SMSF, and this brings us back to the earlier reference to the ATO.

In August 2019, the ATO wrote to about 17,700 SMSF trustees (approx. 3 per cent of all SMSFs), as well as fund auditors, regarding what we have referred to earlier as “having all of your eggs in the one basket” — more formally referred to as the limited diversification of investments of those SMSFs.

Although the intent of the ATO correspondence was to remind trustees of the fact that the lack of diversification should be formally considered, an unfortunate component of the letter (at an early stage in the letter) was reference to penalties for non-compliance.

That overshadowed the intent behind the letters: to remind trustees and auditors of the requirements for the proper formulation of an investment strategy for their SMSF.

SMSF investment strategy requirements

The superannuation legislation requires that SMSF trustees [SIS Act s 52B(2)(f) and SIS Reg. 4.09(2)]:

• “… formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including…:
  
  (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.”

So, while there is little stopping the SMSF trustee from lacking diversification in the investments of the SMSF, the trustee needs to have considered the various risks that may arise from that lack of diversification.

What circumstances may arise where it is likely there will be a lack of diversification?

A number of instances will occur in SMSFs which may result in the fund having significant exposure to one asset class, including:

• the SMSF trustees know and trust investments in property, to the exclusion of other investment options;
• the fund members invest in a variety of investments outside of the SMSF, and their aim for the SMSF is limited to holding a specific type of investment;
• the fund members have most of their super in a public offer fund, but use the SMSF to hold an investment type, such as property, not available in the public offer fund;
• for risk purposes, a decision may have been made to “quarantine” a real estate investment (such as a factory) in a second SMSF, so as not to risk the other SMSF in the event of a damages claim;
• owners of a business establish an SMSF to hold the property from which their business operates, while each also has their own SMSF with their spouse; and
• all available funds are applied to minimise the amount borrowed to acquire an asset under a limited recourse borrowing arrangement, with the eventual aim of broadening the investment range in the future.

Should trustees do anything to rectify the limited diversification?

Not necessarily. As mentioned, the lack of diversification is not the actual issue — the issue is whether the trustee of the SMSF has, as part of the creation or review of the investment strategy, provided adequate consideration to:

• the extent to which the fund investments are diverse, and
• the risks, including potential liquidity issues, from limited diversification.

Effectively, for trustees to be able to prove they have considered the potential risks of limited diversification, they will not only need to have a written investment strategy, but also written confirmation that the apparent lack of diversification, and resultant risks, have been considered.

Therefore, ensuring the investment strategy is up to date and that consideration has been given to the effects of any limited diversification is important.

Would planning for the future be beneficial?

Part of the risk from limited diversification is the forced action resulting from unexpected occurrences.

To plan for such eventualities is an important component of the role a prudent trustee would perform.

In the SMSF environment, that is generally referred to as an “exit strategy”.

Instances where an exit strategy would be of use include:

• the situation of a two-member SMSF with a limited recourse borrowing arrangement, and planning for the occurrence of death, disability or divorce;
• an agreement of business owners in the example covered earlier which could cater for the splitting of the business or the death or disability of a member, including a process to deal with the asset without causing an adverse impact.

Regardless of the ATO requirements, it is important for SMSF trustees to consider the risks which may arise from limited diversification, and the focus on those risks can be beneficial in formulating plans to mitigate any adverse impact.

How can trustees ensure they comply with the ATO requirements?

Step 1 in ensuring compliance is to confirm that the SMSF has a current investment strategy, as that is one of the covenants (the “non-negotiables”) under which SMSFs must operate.

Step 2 is to ensure that it is reviewed regularly — the ATO view is that regularly means at least annually.

Step 3 involves the specific considerations the trustee needs to cover in each review, including:

• the investment risk and likely return;
• the liquidity of the investments, having regard to cash flow requirements;
• the ability to discharge current and future liabilities;
• whether the trustee should hold insurance for the members; and
• the composition of the “… investments as a whole, including the extent to which they are diverse or involve exposure… to risks from inadequate diversification”.

Formally undertaking a review of the investment strategy at least annually, such as when the SMSF financial statements have been prepared, with the review

• ensuring the fund investments are within any parameters set out in the investment strategy, and
• covering the matters detailed in Step 3 above, with particular attention to the diversification aspect, if applicable

will see the trustee effectively covering not only the ATO requirements but also meeting the specific covenant concerning SMSF investments.

More considerations

Mentioned earlier was the fact that some SMSF auditors had also received correspondence from the ATO. That occurred if they had audited an SMSF which has more than 90 per cent of its assets in a single asset class.

The correspondence effectively put auditors on notice to ensure trustees have given adequate consideration to the diversification issues we have covered in this article.

As a result, trustees can expect increased auditor scrutiny of their investment strategy documentation, including the diversification considerations.

Documentation

An anomaly with the investment strategy legislation is that, while the trustee of the SMSF must have an investment strategy, there is no stipulated requirement that it be in writing.

The same applies to the diversification considerations.

However, it would be a very brave trustee who did not support their decisions with proper documents as, without written proof, it is likely the auditor and the ATO will deem that no such investment strategy exists.

Topdocs recommends that an investment strategy be regularly reviewed and, if necessary, it be updated so as to ensure it remains reflective of the trustee’s intentions.

Additionally, if the investments are limited in their diversification, trustee resolutions confirming their deliberations of the risks involved must be prepared.

Conclusion

Having eggs in the one basket is permitted, but trustees need to have considered the risks and difficulties involved.

SMSF trustees have much to think about in the administration of their fund — the degree of diversification of investments is one consideration they should properly document.

Michael Harkin
27 November 2019
smsfadviser.com