Self managed super funds (SMSFs)

SMSFs:

• have fewer than 5 members; and
• all of these members are trustees, or directors of a corporate trustee; and
• there are no other trustees unless it is a single member fund.

Self managed super funds used to be regulated by APRA (Australian Prudential Regulation Authority), but this was transferred to the ATO in 1999/2000.

The ATO has the same investigative powers in respect of SMSFs as APRA has in respect of other regulated superannuation funds and will administer largely similar rules. Prudential concerns will not be a focus, but the primary aim of the ATO is to ensure that SMSFs:

• comply with the relevant provisions of the Superannuation Industry Supervision Act (SIS Act);
  
• are administered in a sound manner consistent with retirement income policy; and
  
• are appropriately using superannuation money for retirement purposes, as opposed to using the money for other purposes such as "investing" in a holiday house.
  

• it has a corporate trustee and the member is either:
  • the sole director; or
  • be one of 2 directors and not an employee of the other director (unless a relative); or
  • it has two individual trustees:
    • one of whom is the member; and
    • the other is not an employee of the other trustee (unless also a relative); and
• no trustee receives remuneration for services performed in relation to the fund.

• the costs are limited to accounting and compliance fees, which for very large account balances are often much cheaper than retail super equivalents; and
• you can invest (without borrowing) in direct real estate as an investment, and subject to rather low limits (5%) you can invest in some "in house assets"; and
• you get to choose the investments for yourself (though be careful, as there are limits on acceptable strategies, and if you invest in something dodgy you not only lose your money but could also get yourself in trouble as the responsible trustee presiding over this mess.)

Self managed super funds have the greatest appeal to people that like direct stocks and real estate over managed funds, or those with sufficiently large balances that they can afford wholesale funds.

Self managed super funds have many disadvantages though:

• compliance costs including accounting, auditing and filing reports can be expensive, probably no less than $1,500pa but could be and usually are much higher; and
• you, as trustee, are held personally accountable for breeches of the rules and can be subject to fines and other penalties; and
• the paper work can be absolutely unbelievable!

How much money makes a SMSF economical?

Accountants I have talked to say $20,000. I ask how the heck they could justify this since costs (before investment expenses) would already be 5%. Apparently most people get into SMSFs because they feel there are tax advantages in super, yet they turn their noses up at investing in managed funds.

I say it is shockingly bad advice to put people with $20,000 into a SMSF. You'd have to be Warren Buffett to reliably add 5% to your returns over the index, why not just invest in an indexed super fund (Vanguard has one) if you don't like managed funds?

So how much money do you need to make it worthwhile? Well for starters I would point out that there are superannuation master trusts with fees around 0.75%pa. As a baseline, one would have to assume at least $1,000pa in SMSF compliance costs and $1,000/0.75% is $133,333. Actually, you could easily be looking at costs of around $2,000 - $3,000pa, so maybe you'd want to put a minimum invest for a SMSF (unless you wanted to buy direct real estate) as two or three hundred thousand dollars. Below that you could buy wholesale funds and direct shares within the wrap much more cheaply than via a SMSF. Apart from in-house assets and direct real estate, this wrap would give all the benefits of a SMSF in terms of freedom to manage it, with none of the hassles.

Lets just use as a basic figure $200,000 as a minimum for a SMSF. This is way more money than most people have when they are thinking of a self managed super fund, but I know a number of people (some of them clients of mine) who were told by accountants that SMSFs are viable with $50,000.

There are other reasons why even $200,000 might be too small to bother. For a start, self managed super funds are a real pain in the neck to manage. Many trees will be sacrificed while you get the trust deed prepared, set up bank accounts for the SMSF (which will have their own fees), brokerage accounts for the SMSF, registering the fund and appointing the trustee and a lot more. This process could take months, I know it takes that long because I know lots of people going through it all now. Those are usually once off things, it is the ongoing that can be a real pain, you have to get accounts done every year, auditing is an expensive and tedious business that accountants hate doing, you may need an actuary if you are making income streams and this guy will cost a bomb, and there are regular reports to be filed with the ATO.

In addition to paperwork, there is legal liability. You become a fund trustee, and will be bound to invest in a prudent manner or else you will be held personally responsible for breeches of the SIS act and other things. Even worse, you can't fall back and blame your accountant or financial planner - as trustee you are responsible. So be careful about trying to pull any stunts with a SMSF, you should probably limit yourself to relatively "normal" types of investments.

In addition, if you do decide to invest in managed funds at all you'll probably have to use retail funds unless you have a lot of money, but with a wrap account once you get past the 0.77% you are able to buy wholesale funds. Add this saving in and you have yet another argument for wraps (at least the cheap ones, not the ones costing almost 2%pa including trail commissions) as opposed to SMSFs, and you may decide on wraps until you get to around half a million, which is in fact the figure that I personally quote as being the point where the high but fixed costs of a SMSF become sufficiently compelling that you would go through all that bother.

Once you do get to $500,000, I think SMSFs can be very useful and might make a lot of sense.

The costs don't scale up linearly the way wrap fees do, so for large account balances SMSFs can be very economical. You also become somewhat less constrained in that you can invest in some of the stuff the wrap account won't let you (though before you get too excited, check out the wrap investment menu first, some of these things have an enormous variety of stuff to invest in).

I wrote a simple spreadsheet, it charts the total cost of running the fund including compliance costs, master trust fees, wholesale MERs (for the master trust) and retail MERs (for the SMSF). You can check it out by clicking here.

Another advantage is that there are some "tricks" that can be used for tax planning in SMSFs. For example, some people exploit a loophole with reserving.

A reserve is a separate account that some super funds (most commonly industry super funds) use to cream off high returns in good years and pay back to members in bad years, thus artificially making the fund seem less volatile than it really is. There are arguments for and against reserving, but I won't get into them.

The loophole some people exploit concerns excess benefits. If you are above your RBL, people using this strategy forfeit their excess benefits to the reserve. This money can then be reallocated to other members of the fund, which can be a handy thing to do if the other members are relatives. Bear in mind that there may be costs of doing this if the member receiving the forfeited benefit might be liable to pay superannuation contributions surcharge on the money if their income is high. It is also possibly a risky strategy legally, while I understand it is in common use such tricks might potentially attract the ire of the ATO some day (part IVA is the section of the tax act dealing with avoidance, and some have suggested that creative use of reserving could violate part IVA if the ATO ever decides to crack down on it), so seek advice from a good tax lawyer before doing this (and you'll need reserving to be an allowable strategy permitted in the trust deed, so you'll need to sort it all out in advance).

Instead of forfeiting an excess benefit that is already there, others prevent an excess benefit ever forming in the first place, by reserving away earnings at a rate sufficient to prevent it happening. I advise great caution and suggest you seek a good tax lawyer (not just an ordinary accountant or financial planner) to make sure you pull it off legally.

Naturally, reserving out excess benefits is not even going to be an issue unless you have more than half a million dollars anyway, so reserving is not a compelling reason for people with small account balances to go with a SMSF, you can always roll over to one later on when a SMSF becomes economical.

(Note that when spouse super splitting is introduced in the near future, it will be possible for a couple to split their superannuation evenly. This will make reserving virtually obselete, and there will be virtually no risk of annoying the ATO.)

Another advantage concerns income streams. Many people just hate the idea of buying a complying income stream and forfeiting their capital if they should die. They also hate sticking a large portion of their money into a conservative investment, especially if they are growth investors.

Complying income streams have many advantages, including asset test exemption for social security purposes and being able to access the higher pension RBL. People just hate them because they don't want to tie up a large chunk of money into a conservative income stream that they may lose if they die earlier than expected.

With self managed super funds, it is possible to create your own complying income streams. There is a lot of paperwork, you'll need an actuary's certificate prepared every year and this won't come cheaply, and to get that actuary's certificate you need to invest in at least a moderately conservative portfolio (one of the rules of a compliant pension is the income must not drop unless the CPI does (deflation), so the investment needs to have a degree of capital protection). Despite these irritations, at least if you roll your own some insurance company won't get a windfall if you keel over one week after sinking half a million dollars into a lifetime annuity with no reversionary beneficiary or guaranteed period, which is the main thing that bugs people about complying income streams.

The Australian Tax Office has a particularly good booklet on SMSFs, called A Guide for Trustees Running a Self Managed Superannuation Fund. Your accountant might provide you with a copy, but dropping in on any branch of the ATO or downloading it from the ATO web site would allow you to peruse some of the other information they have. (See the links section of the FAQ, the ATO links under superannuation will take you to this booklet and a bunch of other stuff). This book doesn't give nifty tax dodging strategies or anything, but it does contain a useful summary and various checklists explaining the annual drill for running a SMSF. Definitely you should read it before considering a SMSF, if it all sounds like too much work then you are probably right.

So to summarise, self managed super funds are great, they do give you more flexibility and open up exciting possibilities for new strategies. On the other hand their minimum running costs are expensive and the break even point of the much maligned retail super funds and wrap accounts vs SMSFs is a lot higher than many people estimate it to be, particularly accountants who may partially be interested in SMSFs because they create new accounting business for the firm, on top of any perceived tax and investment benefits.