04.05.20 Tricks and Traps Auditing SMSF Investment Strategies
1.0 Audit Procedures for Investment Strategies
1.1 The audit procedures required to be undertaken in relation to the Investment Strategies of a fund are as follows:
i) A copy of the fund’s latest investment strategy documentation is to be requested each year. The strategy should be reviewed to ensure:
ii) Any new investments categories invested in during the year are in accord with the strategy.
iii) The strategy adequately addresses the need to diversify investments to reduce investment risk. Specifically, any investment in real estate which exceeds more than 90% of fund assets needs special consideration in the strategy. The strategy needs to address both the diversity risk and the liquidity risk.
iv) The liquidity needs of the fund have been considered, in particular, its ability to meet the pension requirements of the members. Where pension cash outgoings exceed investment income the investment strategy should address this issue.
v) The insurance requirements of members have been considered. It is expected that no retired members would require insurance cover.
1.2 Any minutes of meetings of trustees and other evidence should be reviewed to determine whether the trustees have reviewed the Investment Strategy during the year.
1.3 Where the Investment Strategy has not adequately addressed an issue as required by the Regulations consideration should be given to bringing the issue to the attention of the trustees in the Auditors Letter to Trustees.
1.4 Further, where the Investment Strategy has been inadequately documented, or is otherwise deficient, or not being implemented in the investment decisions of the fund consideration should be given to whether there is a compliance breach. Whether the issue is of a material or significant nature, should be considered carefully before reporting any such breach. The main point to remember is that there is no right or wrong answer in relation to the investment strategy with one exception – the strategy needs to be consistent with the assets that the fund holds.
2.0 Documenting the investment strategy
2.1 Whilst the SIS Act and Regs do not demand that an investment strategy be in writing, it would seem difficult for an auditor to review what is in someone's mind.
2.2 It would seem the use of 0% to 100% investment class ranges wouldn't be appropriate.
2.3 It is a perennial problem for the trustees of any trust – do they explain how they made a decision or do they simply provide details of the decision that has been made? Provide details of how you made a decision and the process you used can be examined and contested. So perhaps the better course of action is to simply record a trustee's decisions on each Reg 4.09 limb and any other relevant point.
When conducting the annual audit on your fund, your auditor will check whether the fund has met the investment strategy requirements under the super laws for the relevant financial year. This means they will check that:
the SMSF had an investment strategy in place for the relevant financial year that considered the factors outlined above
the fund’s investments during the relevant financial year were in accordance with that strategy
the strategy had been reviewed at some stage during the relevant financial year.
Where the fund did not comply with the investment strategy requirements, the auditor may need to notify us about this by lodging an auditor contravention report (ACR).
4.0 What needs to be included in a SMSF’s investment strategy? (ATO guidelines)
4.1 A SMSF investment strategy should be in writing. It should also be tailored and specific to the relevant circumstances of your fund rather than a document which just repeats the words in the legislation.
4.2 Relevant circumstances may include (but are not limited to) personal circumstances of the members such as their age, employment status, and retirement needs, which influence your risk appetite. Your strategy should explain how your investments meet each member’s retirement objectives.
4.3 In particular, under the super laws the strategy must consider the following specific factors in regard to the whole circumstances of your fund:
risks involved in making, holding and realising, and the likely return from your fund’s investments regarding its objectives and cash flow requirements
composition of your fund’s investments including the extent to which they are diverse (such as investing in a range of assets and asset classes) and the risks of inadequate diversification
liquidity of the fund’s assets (how easily they can be converted to cash to meet fund expenses such as the cost of managing the fund and income tax expenses)
fund’s ability to pay benefits (such as when members retire and require a lump sum payment or regular pension payments) and other costs it incurs
whether to hold insurance cover (such as life, permanent or temporary incapacity insurance) for each member of your SMSF.
4.4 When formulating your investment strategy, it is not a valid approach to merely specify investment ranges of 0 to 100% for each class of investment. You also need to articulate how you plan to invest your super or why you require broad ranges to achieve your investment goals to satisfy the investment strategy requirements.
4.5 The percentage or dollar allocation of the fund’s assets invested in each class of investment should support and reflect your articulated investment approach towards achieving your retirement goals. If you choose not to use allocated portions or percentages in your investment strategy, you should ensure material assets are listed in your investment strategy. You should also include the reasons why investing in those assets will achieve your retirement goals
5.0 Potential Matters for the Attention of Trustees relating a fund’s investment strategy
5.1 The key issue is auditors cannot make recommendations about acquiring, retaining or disposing of any financial product. This does not mean that factual issues as required by SIS Reg 4.09 cannot be brought to the attention of trustees with appropriate disclaimers (if required).
5.2 SUPERANNUATION INDUSTRY (SUPERVISION) REGULATIONS 1994 - REG 4.09 Operating standard--investment strategy
(1) This regulation:
(a) is made for subsection 31(1) of the Act; and
(b) applies to a superannuation entity that is a self managed superannuation fund.
(2) The trustee of the entity must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to, the following:
(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.
(3) An investment strategy is taken to be in accordance with sub-regulation (2) even if it provides for a specified beneficiary or class of beneficiaries to give directions to the trustee where the directions:
(a) relate to the strategy to be followed by the trustee in relation to the investment of a particular asset or assets of the entity; and
(b) are given in the circumstances covered by regulation 4.02.
5.3 Here is a list of matters auditors could raise with their clients - In effect we can breakdown the investment strategy requirements in SIS Reg 4.09 and decide how each is satisfied with each current investment and each putative investment:
5.4 Objectives of the fund - 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:
5.4.1 What assets does our fund own now?
5.4.2 How does each investment help the fund meet its investment objective(s).
5.4.3 What assets are we thinking of disposing of or acquiring and why?
5.4.4 How would these investment transactions help the fund meet its investment objectives?
5.4.5 What are the fund's liquidity requirements and do current or future investment holdings help meet or hinder meeting these liquidity requirements? (This is not a one year requirement but multi-year cashflow analysis – see below.)
5.5 Diversification - 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:
5.5.1 Firstly, what do the trustees mean by "diversified"? Broad asset classes – eg cash, fixed interest, property, shares, etc. Or within asset classes – for example, a broad range of ASX listed shares from a variety of sectors? Or a broad cross section of long-standing widely held listed investment companies?
5.5.2 If our fund has nearly all its money invested in a single illiquid investment (for example real estate) then what risks have we identified in holding this single asset and how might those risks prevent the fund from satisfying its investment objective(s)?
5.5.3 Suppose the fund's real estate investments are leased to a third party. If that lessee fails to pay rent or leaves at the end of a lease period and a new tenant cannot be found for an extended period, what impact will this have on a fund's liquidity requirements?
5.5.4 As has happened recently what will happen if the fund doesn't receive rent for at least six months (no trustee will be able to say contemptuously that such an event will never happen and therefore doesn't need to be considered).
5.5.5 Note – it does not seem clear here that a super fund must have a diverse set of investments; this is merely asking us to consider this issue
5.6 Liquidity - the liquidity of the entity's investments, having regard to its expected cash flow requirements:
5.6.1 We have already mentioned liquidity – how are our fund's objectives potentially impacted if we have to fire sale an asset or the bottom falls out of investment markets just as we need to sell assets?
5.6.2 If the fund has an LRBA what is the impact if the lender asks for their money back but the asset is worth less than the outstanding loan? What if the LRBA loan repayments can only be repaid if rent is received and/or compulsory employer super contributions are made to the fund?
5.6.3 How long do we need to consider the fund's cash flow requirements? It would seem prudent to make this at least rolling five years with adjustments to assumptions based on known facts. Any longer than five years and our analysis maybe less useful
5.6.4 If we are paying pensions then does the fund have sufficient expected cashflow even taking into account unusual circumstances such as an unexpected fall in income paid? How many years of future pension income payments and expenses do the trustees intend to hold in cash at bank? (At least 24 months of all expected outgoings is often considered to be prudent.)
5.7 Liabilities - the ability of the entity to discharge its existing and prospective liabilities:
5.7.1 What are existing and prospective liabilities? The former are often relatively easy to determine. The latter might take a bit of careful thought
5.7.2 What would happen if a member benefit had to be paid quickly – for example because of death, disability, compassionate release etc?
5.7.3 What would happen if the fund has more than one member and one of those members wishes to, or needs to, leave the fund – for example divorce? (Many couples may be reluctant to talk openly about this issue but ideally it should be thought about)
5.7.4 Are there any assets/investments that would be difficult to liquidate? Or would take considerable time to liquidate?
5.7.5 Are there any assets of the fund that are jointly owned that require the agreement of all owners to sell the asset? What is the potential for disagreement between owners especially at disposal?
5.7.6 What arrangements are in place to ensure surviving trustees know what needs to happen and how? (That is, do they know and understand how and why the SMSF's funds have been invested?)
5.8 Insurance - whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund:
5.8.1 This requirement is quite self-explanatory – should the trustee hold insurance for one or more members of the fund
5.8.2 A trustee could consider this issue by looking at the insurance each member needs and comparing that to insurance already held whilst also considering if a suitable policy or policies for an appropriate price could be purchased by the SMSF trustee
6.0 Important to understand the historical background the requirements for an Investment Strategy. (Tony Negline – CAANZ)
6.1 In brief
Trustees always had obligation to invest trust monies prudently
Statutory investment strategy requirement has been with us for over 25 years
Became an operating standard for SMSFs in 2012
In February 2020 the ATO released information about SMSF investment strategies.
This publication caused almost as much controversy as the small number of letters the ATO sent to SMSF trustees that had a heavy concentration in a single asset in 2019.
The issue of super fund investment strategies has been controversial for over 25 years. In this article we will consider the history of this requirement and then look deeper into what the ATO have actually said in this latest release.
6.2 Duty to invest trust fund prudently
Trustees can only invest according to the powers and any directions given to them by their fund's trust deed.
If a trustee invests in a way not authorised by their deed they would likely be in breach of trust.
It would be fair to say that most modern SMSF trust deeds give trustees wide powers to invest their super fund's money.
Nevertheless this does not give trustees a completely free hand.
To begin with trust monies must be invested. In 1919, the Court of Appeal of England and Wales determined that "investment" meant "to apply money in the purchase of some property from which profit or interest is expected and which property is purchased in order to be held for the sake of the income which it will yield".
It goes without saying that super funds exist to provide retirement and/or death benefits which may be paid in lump sum or pension form. More specifically super funds must satisfy the legislative sole purpose test – that is, provide at least one core purpose – such as retirement benefits – and, if desired, potentially ancillary purposes.
Over time the courts developed the concept of the "prudent man test" which in this age is now often referred to the "prudent person test". This test was defined in another court case before the Court of Appeal of England and Wales from 1886 "a trustee ought to conduct the business of the trust in the same manner that an ordinary prudent man of business would conduct his own… the level of skill to be exercised by a trustee is that which a person of ordinary prudence would exercise in dealing with the property of another person for whom he or she felt morally bound to provide." (our emphasis)
In April 1992, the Australian Law Reform Commission (ALRC) published a report on superannuation law reform (Report No. 59). In relation to the prudence test it said:
"This is not only a high standard, it is an objective standard. Acting honestly, while a fundamental requirement, is not sufficient."
Even though a trust deed may permit a wide range of potential investments including highly speculative ones, a trustee is still under a duty to act prudently and in good faith. It is still possible for a trustee to invest the funds inappropriately even though the investments were permitted.
The key points are that a trustee can make mistakes but at all times it must objectively be the case that a trustee has invested money prudently.
6.3 The SMSF unique structure
As we all know there must be a very close relationship between SMSF trustees and their members (in the vast majority of cases they are the same people). There will only be a few SMSFs that do not have beneficiaries apart from these trustees/members. For example in many cases non-trustee beneficiaries might be entitled to receive a death benefit.
The vast majority of SMSFs have two members and in nearly all cases these members are spouses.
Disputes between SMSF trustees/members are quite common especially because of relationship breakdowns.
It seems perfectly logical to argue that a SMSF trustee can invest their money according to the whims and wishes of members because after all it is their money. As we shall see there is a regulatory process SMSF trustees can use to effectively make this preference happen. But the question then become have the trustees acted prudently – that is, "which a person of ordinary prudence would exercise in dealing with the property of another person for whom he or she felt morally bound to provide"?
6.4 Super law investment strategy requirement has been with us for over 25 years
The government adopted the SIS Act as government policy in October 1992 in a document titled "Strengthening Super Security" which said that,
The Government considers that one of the essential duties of trustees is to invest in a manner that seeks to maximise the rate of return on members' entitlements commensurate with a prudential approach to risk. The Government believes that this can best be achieved by encouraging trustees to adopt a balanced portfolio approach to the investment of members' funds. This means that trustees should generally invest fund assets across the full range of investment opportunities with their portfolio typically being spread between a range of major asset classes including cash, fixed interest securities, equities, property and other assets. Portfolio diversification of this type can be expected to lessen risk as well as to generate higher returns over the long run. To encourage trustees to adopt the portfolio approach, the Government intends to codify in legislation the "prudent man" rule provisions contained in comparable United States legislation (Employee Retirement Income Security Act 1974).
The adoption of a balanced portfolio approach will allow trustees to invest a proportion of funds in areas such as venture capital without breaching their fiduciary obligations. The Government acknowledges the potential that such investments can have in helping funds to achieve a relatively higher rate of return. This will not only benefit members but will also provide long-term benefits to the Australian economy in terms of economic growth.
The codification of the "prudent man" rule will not inhibit the operation of specialised wholesale superannuation investment vehicles which may follow a less diversified investment pattern. These vehicles would allow superannuation funds to hold a diversified portfolio, for example, by investing in several wholesale vehicles, while benefiting from the investment expertise that such vehicles could offer.
The Government considers that the interests of superannuation fund members in having their long-term savings invested in profitable sectors of the economy are compatible with the Government's national interest considerations of ensuring that Australia has a strong, innovative and internationally competitive economy.
6.5 The explanatory memorandum introducing this legislative requirement did not explain what the investment strategy requirement meant and why it was being implemented.
Nevertheless it is quite clear from the above that the government has been attempting to push diversified investment portfolios. That is diversified portfolios to mean a range of asset classes.
However it would be fair to say that the wording of the factors trustees need to consider when drafting an investment strategy requirement do not demand that a diversified portfolio be put in place. There is only a demand that this issue be considered.
6.6 As noted above the investment strategy requirement has been an operating standard for SMSFs since July 1996. This means that for over 20 years the regulator has had the ability to impose penalties for non-compliance with this requirement. And the ATO now has the added ability to impose an administrative penalty.
From 1 July 2004, SMSF auditors were asked to confirm that SMSFs had complied with the investment strategy requirement.
From 7 August 2012, SIS Reg 4.09's opening paragraph was changed from:
The trustee of the entity must formulate and give effect to an investment strategy that has regard to all the circumstances of the entity, including in particular:
to the following:
The trustee of the entity must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to, the following:
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