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Is $1 million now the new $200,000?

27/08/2018

Previously, the Australian Securities and Investments Commission (ASIC) has suggested that operating a self managed superannuation fund which had less than $200,000 of investible funds (well, probably now $202,315 – due to inflation since the suggestion was first made) was probably unviable.

Now it seems that the Productivity Commission, in its recently released (29 May 2018) draft report "Superannuation: Assessing Efficiency and Competitiveness", has concluded that SMSFs with less than $1 million are "not competitive" in terms of net returns against retail super offerings.  The implication of this conclusion is that any SMSF with less than a $1m cannot be justified (or, at least justified solely on the grounds of net performance) as being in the members best financial interests.

In determining the net return of a super fund, the Commission has, in broad terms, taken gross investment returns and then netted off all costs (not just costs relating to investments – but costs of "running" the SMSF other than insurance costs).

There are two comments which can be made against this implication.

The first is that SMSFs have features and non-financial benefits which must also be taken into account when considering whether it is in the best interests of the members of the SMSF to retain their super balance in the SMSF or to transfer their super balances to a large retail or industry fund.  The non-financial benefits of SMSFs particularly relate to estate planning.

The second is that the Productivity Commission has not been fairly quoted – the point the Commission was making (for example refer to Draft Finding 3.3) is that net returns for SMSFs are weighed down because of relative high costs which reduce the amount of investible monies – particularly, high costs associated with the SMSF merely as an entity.  These costs include accountancy fees, legal fees, administration fees, audit fees and, nowadays, fees associated with electronic service addresses.  

As to the first comment – some of the features unique to SMSFs (and not to retail funds or industry funds) include the following:

1.       Control:

SMSFs offer control to their members: control over the investment strategy; control as to the nature and type of benefits to be provided and control over the succession to death benefits.

And control over investments is not the only autonomy attractive to SMSF-ers.  There’s control over how the fund is administered and by whom, control over the release of funds (ever noticed how slow public offer funds are to release money, especially when the member is rolling over to another fund?).

2.       Unique investment opportunities:

For example, can retail or industry funds allow their members to undertake the following investments?

(a)    Buy residential real estate

SMSFs have been unfairly picked on for supposedly gorging themselves on homes in first home buyer territory to the detriment of first home buyers (in fact, according to the ATO, only 4% of SMSFs’ total assets are invested in residential property).

But the reality is that residential real estate has (for everyone out there who timed it right, not just SMSFs) been an outstanding investment for SMSF members – and in many cases SMSFs have generated far better returns than the big retail funds whose only options for members is to just stick their money into ubiquitous (and commission paying, and often vertically integrated) managed funds.

(b)   Buy your business real property from you

Can anyone seriously claim that someone who set up an SMSF to buy their business real property from them (perhaps a commercial strata unit worth a "mere" $500,000), is running their business from it and paying (and claiming a tax deduction at maybe 45%) for market rent to their own superfund taxed at only 15%, with the prospect of retiring one day and selling the unit in pension phase capital gains tax free, regrets not having stuck their hard earned dollars into a big retail fund instead?

We’d really love to see an Industry Super Funds’ "Compare the Pair" TV ad example on that one!!

(c)    Let you borrow to do either (or both) of the above

Now here’s the rub – just because you might not have a whole lot of money to start up your SMSF doesn’t mean you can’t buy that residential property or business real property, because you can borrow money – including from a related party – to buy it under a Limited Recourse Borrowing Arrangement.

So looking again at the business real property example above, let’s now factor in that the member’s own family trust lent the money to the fund (at market rates of interest and on full commercial terms) to do the deal.  On top of the advantages already mentioned, now add:

(i)      market rates of interest being paid to a discretionary family trust with the interest being claimed as a tax deduction for the fund and the family trust distributing the interest income tax effectively – and if the trust happens to be a discretionary testamentary trust, that interest can be allocated to minor beneficiaries completely tax free up to the adult tax free threshold; and

(ii)    the benefits of LEVERAGE to MULTIPLY the earnings per dollar actually invested by the member – so a 3% return gross on a maximum 70% LVR means a real return per dollar invested of 10%!!! Much, much better than what the top 200 Australian superannuation funds were averaging for the years 2004 to 2013.

Clearly there is no comparison here between "low balance" SMSFs and the big public offer retail super funds when you factor in all the unique abilities of SMSFs to invest members’ funds – the "low balance" SMSFs win hands down!

3.       Estate planning flexibility:

However, now we come to the crux of the matter.  As they say, death is one of the certainties in life, and whilst the sole purpose of a superannuation fund is the provision of retirement benefits in most cases there is likely to be something left over when the fund member dies – in some instances (especially where life insurance is taken out via super) quite a substantial sum of money, and perhaps well over $1 million at that.

Given that a superannuation fund (SMSF or otherwise) at law could ultimately be a discretionary trust because the fund trustee has a discretion regarding to whom to pay a death benefit (amongst the “SIS dependants”), PLUS given the fact that on the death of a member that death benefit may be pretty large (and in the case of young people who die before having the opportunity to build significant wealth in their own names, quite possibly that death benefit is THE most significant part of their "wealth" – as it was in the case of McIntosh v McIntosh [2014] QSC 99 (where the net assets of the deceased were about $80,000 but his interests in various super funds totalled approximately $454,000), it is absolutely imperative that a fund member make a Binding Death Benefit Nomination (BDBN) to direct the trustee of the fund regarding how and to whom to pay their death benefits.

Unfortunately this is where the big public offer retail super funds are sorely lacking.  Most only offer members the ability to make a BDBN with a single level of nomination (so you can nominate one or more persons and / or your estate in varying amounts, but you cannot nominate a further level of beneficiaries if none of the persons at the primary level are able to accept payment) and with a three year expiry date – so that if you don’t remember to renew the BDBN within the three year period, the nomination lapses and the trustee’s discretion rules again.

In fact, dying without a valid BDBN can be actually worse than dying without a valid Will – at least if you die intestate, the State or Territory laws provide for a statutory order of persons to whom your personal estate will go to when you die.  Not so with super – the fund trustee has an absolute discretion regarding to whom to pay your death benefits – even all to themselves against the member’s express wishes (see the classic case of Katz v Grossman [2005] NSWSC 934 for a wonderful example of this!).

In recent years, some public offer retail super funds have been offering a Non-lapsing BDBN, but that’s about the most you can hope for from these funds.

Whereas with an SMSF, you can have much greater flexibility, subject only to the terms of the relevant fund trust deed and the requirements of SIS law as regards to whom and how the benefits may be paid.

This ability is particularly important for fund members who are in a "blended family", where the restrictions of a public offer retail super fund are completely inappropriate.

For example, suppose Marge is a widow with three adult children, Bart, Lisa and Maggie.  She meets Daffy, a widower with three adult children Huey, Luey and Duey.  Marge and Daffy hit it off and get married.  Neither of them has a lot of money.  Each of them has around $400,000 in super, and they pooled their other assets together to buy a modest house to live in as tenants in common in equal shares.  Their estate planning objective is to look after each other in terms of somewhere for the survivor of them to live and something to live on, then when the survivor of them dies their respective assets are to go to their own respective children.

That means under their Wills they will give each other a right to live in the deceased’s half of the home until the survivor of them dies, whereupon the deceased’s half of the home goes to their own children.  To support the survivor during their life, they want to give each other a lifetime pension from their super death benefits (because there isn’t enough in their personal estates), and then, on the death of the survivor of them the death benefits are to go back to the children of the deceased fund member – or failing that, to the fund member’s estate for the benefit of their grandchildren.

There is NO WAY that a public offer retail super fund will allow Marge and Daffy to make a Non-lapsing BDBN that will achieve all those ends. This strategy is ONLY possible with an SMSF with an appropriately worded trust deed (such as a SUPERCentral SMSF trust deed).