Is Your SMSF Investment Strategy Meeting Diversification Requirements?
Recently the ATO has contacted some 18,000 auditors and trustees of self-managed super funds (SMSFs) which hold 90% or more of the fund’s assets in one asset or a single asset class. It is important that SMSF trustees and auditors understand the regulations in relation to diversification requirements and investment strategies.
Can a SMSF hold 90% of its assets in a single asset, or in a single asset class?
The short answer is yes, a SMSF can hold 90% of its assets in a single class or in a single asset class. However only if the investment strategy complies with the Superannuation Industry (Supervision) Act 1993 and Superannuation Industry (Supervision) Regulations . Of course, SMSFs must also satisfy the sole purpose test.
The regulations require trustees to implement investment strategies which have regard to a range of factors including risk, liquidity, and diversity of investments. A lack of diversification can expose a SMSF and members to unnecessary risk if a significant investment fails. However, diversification of assets is only one factor which must be considered.
Investment in a single asset or asset class is not necessarily a sign of a poor or non-compliant investment strategy. Asset allocation and diversification must be carefully considered, but SMSF trustees should not be alarmed if diversity is not the key priority of an investment strategy so long as the reasoning for this is justified and properly documented.
What do the regulations say?
Regulation 4.09(2) of the Superannuation Industry (Supervision) Regulations 1994 outlines the obligations of SMSF trustees in relation to investment strategy. This regulation requires that a trustee of an entity must formulate, review regularly and give effect to an investment strategy that has particular regard to the whole circumstances of the company, including a range of factors. These factors are:
(a) 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;
(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;
(c) the liquidity of the entity’s investments, having regard to its expected cash flow requirements;
(d) the ability of the entity to discharge its existing and prospective liabilities;
(e) whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund.
Therefore, diversity is only one factor which must be considered by the trustee. In some circumstances, it will be appropriate for other factors to be weighed more heavily in an investment strategy.
How can a trustee ensure that a SMSF’s investment strategy is legally compliant?
- In formulating an investment strategy for a SMSF, a trustee must accurately document the investment strategy of the fund, including objectives, investment choices and policies. This strategy must justify decisions in relation to how the asset allocation with respect to factors such as risk, diversification, liquidity, cash flow requirements, ability of the fund to discharge liabilities (including member balances), and life insurance. Of course the trustee’s decisions will depend on the objective of the fund. For example, if a SMSF has an aggressive objective, the trustee may be able to justify the fund investing in a riskier asset allocation than a fund with more conservative objectives.
- Asset allocations should be appropriately recorded in the investment strategy. While target ranges may allow flexibility, these should accurately reflect the investment strategy and objectives.
- The trustee must not only document the investment strategy, but also the factors that were considered in creating, reviewing and giving effect to the investment strategy. For example, this documentation could be in form of a questionnaire answered by members, correspondence to members, or notes recording conversations with members. If members cannot give adequate instructions relating to the asset allocation or insurance, they should be referred for financial advice.
- The trustee must review the SMSF investment strategy regularly. The Australian Taxation Office have indicated that they consider regularly to mean at least once per year. The trustee must document the outcome of the review in a trustee minute, regardless of whether the strategy is varied or maintained.
- The trustee should not only be reviewing the appropriateness of the investment strategy, but also the fund’s compliance with that strategy. If the asset allocation of the fund differs from the investment strategy, it cannot be said that the trustee has given effect to the investment strategy.