SMSF - the Secrets of Self Managed Superannuation Funds

SMSF is short for Self Managed Super Fund. - Some like to call it DIY super, DIY superannuation fund or do it yourself super. In the end, these names all mean the same. The official term used in super legislation is a self managed superannuation fund.

A Self Managed Super Fund (SMSF) is a special type of fund in contrast to other superannuation funds in Australia. It is a small superannuation fund with up to four members and is controlled and operated by its members. For example, that could be you, your spouse and children.

This way you gain the big advantage of making your own decisions about how to invest your super.

The fund accepts contributions from its members and their employers. It pays benefits on retirement and on other very specific occasions as detailed by the relevant laws. A super fund follows a certain purpose. This is also known as the sole purpose of the fund.

SMSFs are bound by the same Superannuation Industry (Supervision) Legislation (SIS) like the big retail, corporate, public sector or industry funds. In contrast, however, they're regulated by the Australian Taxation Office (ATO).

SMSFs own about 32% or $330 billion of all superannuation assets in Australia (afsa, July 2009). They are very popular and their total number base is growing the strongest compared to other types of funds. The key motivation is that everyone wants to have better control of their own long term super investments even if it's not accessible as yet. Australians want to make sure they'll have enough wealth for retirement.

What makes a self managed super so attractive?

First of all, we're talking about superannuation here. We need to remind ourselves that super is the tax haven of Australia with many tax concessions for everyone. If you add to this the gaining of complete control of your super assets you get a strong case for using SMSFs. It is also about managing your own and your families' own retirement money.

Benefits go beyond just tax advantages. All the members are trustees of the fund and in direct control of investment strategies, retirement benefits and death payments. Trustees gain wider access to investment options in the market. You'll have more flexibility and choice than with other types of super funds that have preset and limited investment menus.

A self managed super fund can also save you on fees that otherwise are paid to, e.g. portfolio managers. Or, it can pool contributions and existing moneys for up to four members and buy larger investment assets than one individual member can buy.

It can even enter into joint ventures. For example, several SMSFs of a larger multi-generational family join up to buy the property of the family business. Cash in super is then released and withdrawn from the fund as payment for the property. Not only has the joint venture bought the family business property but the business now has additional cash resources available to grow the business.

Flexibility and control of SMSFs allow you to define your own wealth creation strategies and reach financial freedom faster hence diy super (do it yourself superannuation).

So what are the drawbacks? - Whilst advantages certainly outweigh disadvantages there are a few points to consider. The initial set up costs can be significant, e.g. between $2,000 and $4,000. Accordingly, it doesn't make sense to establish a SMSF with a small total balance. The ATO prefers to see SMSFs with combined assets of $200,000 or more.

Personally, I have a more distinguished view. My rule of thumb looks something like this:

• At least $200,000 of combined assets (i.e. for all members) if future contributions are small or irregular, e.g. self-employed with limited cash flow.
• At least $100,000 of combined assets if future contributions are strong, e.g. high double incomes.
• At least $50,000 of combined assets with good ongoing contributions if used for a specific purpose, e.g. to provide essential insurance that could not otherwise be obtained.

Another drawback is the necessary time for trustees to manage their affairs. In addition, legislation prohibits the payment of any kind of remuneration to trustees for looking after their self managed super fund.

Thankfully, product and service providers are geared up for SMSFs and have plenty of platforms and admin tools available with real value for money benefits so that trustees can reduce their admin to a minimum. This frees up valuable time to work on financial strategies and performance instead.

The advantage of being in control can also be a disadvantage in itself because you and your fellow trustees remain ultimately responsible for the fund. You cannot delegate this to a service provider, no matter how professional they are.

What can a SMSF invest in?

Super legislation is very strict and there are investment and other rules that apply. However, there are cherries of financial strategies that are only possible with SMSFs as opposed to other funds.

First, we must know a few rules. This can be a bit technical but trustees need to know them.

A SMSF must

• be run for a sole purpose at all times, e.g. no artwork for your own enjoyment;
• have an investment strategy with objectives - preferably measurable and in writing;
• not borrow any money (certain exceptions apply);
• be run at arm's length, i.e. on commercial terms;
• comply with acquisition rules, e.g. a member's property cannot be acquired by the SMSF; and
• comply with in-house asset rules, e.g. cannot use super money to run a business or build a property.

Let's turn to the more exciting investment options that are available for SMSFs. We know that when investing, it is wise not to put all your eggs into the one basket. The same applies for superannuation funds.

An investment strategy of a self managed super fund typically defines a well balanced and diversified investment portfolio. This can be achieved by selecting different types of investments within or across different asset classes such as:

• shares,
• managed funds,
• fixed interest,
• artwork,
• collectibles,
• property,
• derivatives,
• structured products,
• protected investments,
• cash, term deposits etc.

Diversification of investments and the investment time horizon are important aspects of managing risks and returns. Trustees must consider these when designing their investment objectives and strategies. In the case of derivatives, a special risk management statement must be established.

It is possible to follow a single asset strategy instead of a diversified multi-asset strategy, e.g. the fund invests in property only. The trustees must come to the conclusion that by doing so the risks are manageable and objectives can be met.

According to the statistical report for SMSFs (ATO, March 2009), the majority of all Australian SMSF moneys (32%) were kept in cash, debt securities and term deposits followed by listed shares and equities (25%) and property (14%). This means that most trustees sit in cash waiting for an opportunity to invest in recovering stock markets and property cycles.

Investment principles for superannuation are basically the same as for any other non-super investment. The only thing that is given is the time frame because under normal circumstances super cannot be withdrawn until the member retires.

We'll now have a closer look at one particular strategy which is investing in property through a SMSF. This is getting a lot of interest from trustees and the wider public at present.

How to use super to buy property?

Australians love property. In fact, 1 in 5 households own an investment property but less than 4% have used their super to buy one. The reasons are that super funds are not allowed to borrow, and, SMSFs with smaller balances can't afford a large lump sum investment like property.

A change in legislation in September 2007 has opened up a window of opportunity. You can now borrow money for purchasing an investment by instalments. The investment must still be an asset that the super fund is allowed to invest in. The structure that makes this possible is commonly referred to as an instalment warrant. It is based on an exception to the borrowing prohibition of super funds.

Instalment warrants can be used for property but also work with shares or managed funds. Trustees have used instalment warrants on shares for many years even though there was no clear explanation in the legislation that officially allowed them to do so. It was considered borderline then but is fully accepted now, e.g. the Telstra share offer a few years back was a similar arrangement where trustees paid for Telstra share in instalments.

The instalment warrant structure

Instalment warrants work a treat with property. So, how do property warrants work?

As a start, it is necessary to have a complying SMSF, of course. In addition, a separate trust is required to hold the investment property on trust for the self managed super fund. We call this trust the property trust or security trust (when used for securities instead of property).

The property trust will be the legal owner of the investment property and hold the investment property on trust until it's fully paid for by the SMSF. The SMSF is the beneficial owner of the property and can receive the investment property from the property trust after the final payment is made.

Next, we need to identify an investment property meeting the usual lender's eligibility criteria such as type of property, location, market value etc.

Let's make an example:

Jim and Katie are members and trustees of their self managed Smith Family Superannuation Fund. They earn $80,000 each and have a combined super balance of $150,000. They consider purchasing an investment property for $400,000. The SMSF makes an initial deposit of $100,000 and the trustees apply for a superannuation loan to borrow the balance of $300,000 from a compliant lender.

The following schematic shows the overview of the required instalment warrant structure applied to the property that Jim and Katie want to buy. Its purchase price, as said, is $400,000 and the rent is the income from the property that will flow back through the Security Trust into the SMSF.

In addition to the rent, Jim and Katie will receive a minimum of 9% of their salaries paid as employer super contributions into their SMSF. This is worth $14,400 per year which will assist them in fast paying down the SMSF Loan.

Making the structure work

Initially, the Smith family super fund pays the first instalment, i.e. a deposit of $100,000 which equals to 25% of the property purchase price. The required deposit amount will vary depending on the chosen lender's gearing policy. They also pay the purchasing costs of, say, about 5% of the purchase price or $20,000 for loan costs, legal fees and stamp duty. This leaves them with $30,000 of cash reserves in their fund.

Note that it does not make sense to heavily gear in a super fund because a SMSF gets many tax benefits already anyway when compared to non-super gearing.

Once a super loan is set up, the cash flow of the super fund must be able to pay the interest on the loan, periodic loan repayments and associated costs with the investment property such as maintenance, repairs, council rates, etc.

Repayments are seen as instalments which can vary in size and frequency. Each time the Smith family super fund receives additional funds from contributions and rent it can make another instalment payment until the loan is fully paid down. During that time the property will be held on trust until the final instalment is paid or the property is sold. The SMSF receives all the capital growth along the way too.

How To Use Super As A Deposit To Buy Property?

Been there, done that! ... or are you thinking about it? Tell us your experience with using a self managed super fund for investing in property.

Do you think instalment warrants work well? What makes such an investment structure worthwile?

What are the rewards?

Although the Smith family super fund requires an instalment warrant for investing in a property, it looks fairly similar to other property investment arrangements. However, the big benefits result from using self managed super instead of any other ownership structure.

These benefits are:

• Wealth Creation through gearing – Borrowing to invest allows your SMSF to accumulate superannuation assets faster and provide more assets and income for retirement. It gives you the opportunity to increase your wealth and returns in a way that without borrowing would not have been achievable.
  
  
• Affordability - A benefit of borrowing in super is that potentially you can afford to borrow more or to make instalment payments faster as you are teamed up with other members. The servicing on the loan can be funded not only from the tenant's rental payments but also from employer’s compulsory 9% super contributions, salary sacrifice contributions, personal and spouse contributions, pooled contributions from all the members and the Government co-contribution.
  
  
• Simplicity - Super is now simpler and more flexible because there are no restrictions on how much you can withdraw in retirement and no requirement to withdraw any funds ever.
  
  
• Time To Succeed – Super investments are locked away until you retire and you are free to keep them for longer. This buys you time to make your investment a success.
  
  
• Reduced Risks - A key feature of property warrants is that the borrowed funds are advanced on a limited recourse basis, meaning the only amount you stand to lose is your original deposit you paid out of your super fund and down payments on the loan protecting your other assets from creditors including any other investments you may have in your SMSF portfolio.
  
  
• Efficiency - There is a maximum of 10% capital gains tax on the sale of the investment property if held for at least 12 months and potentially nil if sold in pension phase (retirement). There is a maximum of 15% tax on rental income and potentially nil in pension phase. The interest cost of the instalment warrant, other loan costs, property expenses, property depreciation are potentially tax deductible and can reduce the effective tax rate of the SMSF to nil.
  
  

What are the results?

We have calculated the financial outcomes for the investment property of the Smith family super fund assuming 3% inflation, 4% capital growth, $390 rent per week with a vacancy rate of 2%, $7,200 or 9% employer super contributions for each, principal and interest payments on the loan over 25 years at 7%.

There are more parameters we could throw in but this gives us a good indication already of what we can achieve. Now, we also assume that the property will be sold after 10 years and compare this to a non-super investment.

The end result is nothing short of magic:

Jim and Katie are a total of about $132,000 better off by buying the investment property in the Smith family super fund rather than in personal names.

This figure results from about $25,000 less in capital gains tax in super (if sold after 10 years), fast down payments on the superannuation loan of about $38,000 due to positive cash flow situation and negative gearing holding costs in personal names about of $69,000.

This means that there will be $132,000 more available for retirement generated from exactly the same property held for the same number of days with same outgoings, costs and exposure to risks as if held in personal names. Not to mention that you'll also be able to save about $15,500 of capital gains tax if the property wasn't sold but held until pension phase in retirement instead.

Who wouldn't you want to achieve that?

This is only one of the magic SMSF strategies that we can use to improve our personal finances. Needless to say that this is not possible with 'normal' superannuation funds.

SMSF and property

We have compiled an informative and easy to understand eReport called "The Facts About Using My Super As A Deposit To Buy Property" (pdf-file, 255KB), which you can download automatically with the following self-service form.

Here's a brief outline of its contents:

• Super Leveraged Property Investments
• Powerful Wealth Creation Program
• Australia - The Superannuation Tax Haven
• The Property Warrant Structure
• Questions and Answers - The Technical Stuff
• The Winning Edge
• The Strategy

How to set up a SMSF

Self managed super gives us control and flexibility, i.e. access to great investment strategies that are not possible elsewhere. It is a separate entity and must be set up in a particular manner which we'll cover below.

It is fairly straightforward to establish a self managed super fund. However, a property warrant strategy like explained above requires specialist knowledge and I strongly recommend you seek professional advice in that regard. For example, you don't want to find out later that you will have to pay stamp duty when transferring the property into your SMSF just because the structure wasn't set up properly.

The simple steps of setting up a self managed super fund are:

1. Get a trust deed - You can purchase standard trust deeds from one of the major providers or through a financial planner or accountant. Note that these might require some amendments for specific needs such as instalment warrants and should be checked with a legal practitioner.
   
   
2. Appoint the trustees - The trustees are responsible for the SMSF. You can choose a corporate trustee or individual trustees. The trustees must sign a trustee declaration confirming that they understand their duties and responsibilities.
   
   
3. Nominate the members - Remember all trustees must be members and all members must be trustees.
   
   
4. Send election to the ATO - You must lodge an election with the ATO for your newly established super fund to become regulated. This means the fund will be subject to superannuation legislation and be entitled to concessional tax treatment.
   
   
5. Apply for ABN and TFN - The trustees are required to apply to the ATO for an Australian Business Number (ABN) and Tax File Number (TFN) for the fund. Registering for GST is optional; usual rules apply. Sometimes this can be beneficial, e.g. to claim back GST on tax-effective investments.
   
   
6. Opening a bank account - With the above information you're ready to open a bank account. You can transfer and consolidate existing super of all the members into that account. Now, funds are ready for investing.
   
   
7. Prepare the investment strategy - An investment strategy defines the overall objectives of the fund; how the funds of the SMSF will be invested; and how they are diversified. You may need an additional risk management strategy for some investments such as derivatives.
   
   
8. Organise insurance for members - Recent legislation states that super funds must offer insurance such as life, TPD or income protection to their members. This is also good practice for SMSFs.
   
   
9. Select suitable service providers - The use of financial planners, accountants, fund administrators and other professionals will give your SMSF the extra edge to implement your strategies successfully and to navigate superannuation legislation and investment markets to your advantage. Note that a super fund must have an independent auditor too.
   
   

Once these steps are taken it is a matter of analysing the funds overall financial situation including cash flow position from future contributions and returns. The trustees then match this up with investment strategies and go about implementing them. Of course, this involves an entire financial planning process specifically for the super fund resulting in an implementation plan with suitable financial strategies.

Trustees have very important duties and all trustees must have an understanding of what these are when running a self managed super fund. We have linked the official ATO document called Running a self-managed super fund - Your role and responsibilities as a trustee (pdf, 512KB) (March 2009) for your perusal to this page so you can find out more. This is one of the best documents the ATO has produced so far.

Another resource I would like to share is the brochure from one of the main players in investment markets. The brochure is called Self Managed Super Funds and you (pdf, 631KB) and is similar to our online guide looking at things from an investment angle. It also contains some valuable SMSF tips.

SMSF alternative

If members want to have control but not have the trustee duties they can set up a Small APRA Fund (SAF) which is an alternative to self managed super funds. The trustee must be an approved service provider, i.e. approved by APRA (Australian Prudential Regulation Authority) and the fund is also regulated by APRA instead of the ATO. There is no prohibition of remuneration for trustees of SAFs.

More information:

Superannuation Australia
Superannuation Funds
Lost Super
Annuity
Centrelink Australia
Retirement Calculator

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