The final report of the Financial System Inquiry, which was released last month, asked the federal government to restore the general prohibition on limited recourse borrowing (LRBAs) by superannuation funds.
We believe that there are multiple reasons why this recommendation won’t be adopted.
Firstly, the prohibition on borrowing in super was originally lifted to remove uncertainty with instalment warrants.
There was a concern that while you have an instrument that in the very general sense of the word could be seen as a security, it is actually structured under Australian law as a loan.
There are significant differences in risk exposure between investing in direct property via a limited recourse borrowing arrangement and investing in an instalment warrant.
The risk that the inquiry is talking about seems to be more oriented around risks associated with the real property market rather than risks that would be associated with investing in vanilla instalment warrant products.
The recommendation does not seek to distinguish between those two scenarios.
Section 67A is an extension of the original exemption which was inserted to allow super funds to invest in instalment warrants like those offered for example in ‘T1′ and ‘T2′ issues of Telstra securities.
It was intended to remove doubt about whether such an investment involved ‘borrowing’, so removing it will simply reintroduce that doubt.
An across-the-board ban on borrowing may therefore be unwarranted unless the government believes instalment warrants pose a similar level of systemic risk as borrowing to purchase property.
Secondly, it seems unlikely that the government will risk “political capital” by banning LRBAs outright.
The recommendation is only one of the 50 points put forward by David Murray and out of most reviews, generally only five percent of all recommendations are taken up.
Recent research has revealed that almost 85 per cent of SMSF members aged 18 to 64 do not hold life insurance cover.
The research house found that over 630,000 individual SMSF members do not hold insurance, particularly in the Gen Y, X and baby boomer brackets.
This number of uninsured SMSF members is alarming, showing an enormous gap that needs to be addressed.
Part of the reason for the underinsurance, potentially, is that many trustees rely on an expert to assist them in their role as trustee and more often than not that expert is their accountant.
Accountants generally don’t have the authority to act as a financial adviser as well, so they aren’t raising the issue of insurance sufficiently with these trustees.
There is a significant opportunity for advisers to capitalise given the number of SMSF trustees that don’t have insurance.
While it is a great opportunity, the real concern here however is the personal situation of the self-managed super fund members.
They must take a serious look at protecting themselves and their family and their assets appropriately.
Below is a discussion about and list of the different types of insurance available to SMSF trustees and avenues to explore taking up these policies.
What are the advantages of holding your personal insurances inside of a SMSF?
- Provides protection against life events for the SMSF members.
- Tax effective when compared to holding and paying premiums as an individual.
- Use accumulated funds to pay for SMSF held insurances, better cashflow benefits than paying from your own wallet.
Disadvantages of having insurance in a SMSF:
- Tax is payable on some Life insurance and TPD benefits.
- Contributing to your SMSF solely to pay the insurance premiums are still counted against your super cap.
- Using SMSF funds to pay premiums will reduce the amount that you have to spend in retirement.
- Restrictions on the features and benefits available when compared to those held in your personal name.
Insurance products a SMSF can purchase:
- Life insurance
- TPD insurance with an “Any” Occupation definition
- Standard Income Protection insurance only
Insurance products a SMSF cannot purchase:
- TPD insurance with an “Own” Occupation definition
- Trauma insurance
- Comprehensive Income Protection insurance
How do I go about taking out SMSF insurance?
…speak to AIIG on 1300 730 797, we access all life insureres in Australia and provide advice as to why a policy is better suited to your needs than another one.
You will be asked during the application process who will own the policy. Where the SMSF is to own the policy then the trustees of the SMSF (or the trustee company) will be listed as the policy owners “as trustee for” the superannuation fund and the premiums will be paid from the fund’s account.
Why should I have insurance within my SMSF?
In August 2012 as part of its move towards “Stronger Super” the government introduced superannuation regulations requiring trustees of SMSFs to annually consider the insurance needs of their members.
As a result SMSF trustees need to consider whether to take out cover for each of their members and review this annually. In meeting this requirement the Trustees should consider the personal circumstances of each of the members of the fund including their income, assets and liabilities, any existing insurance cover they have and how they or their family would be impacted by their death and disability. Also it may be relevant to consider how the insurance could be used by the fund to extinguish liabilities or otherwise avoid having to dispose of a large asset to pay a benefit to a member.
This insurance strategy needs to be documented at least annually in the SMSF investment strategy or in the minutes of a trustee meeting. There are penalties which will apply if the trustees fail to address insurance in their SMSF.
Even without this legislative obligation there are a number of good reasons why the trustees of a SMSF should purchase insurance policies for their members.
Advantages of having insurance owned by your SMSF:
- Protection of members
Where a SMSF member is still working and accumulating wealth their death or disablement is likely to have a devastating effect on their family, particularly if they have debts and dependant children. In this case there is a strong need for Life insurance and TPD insurance which will provide a lump sum payment should this happen. For members who are retired with sufficient funds in their super fund to provide for their dependants in the event of their death or disablement this insurance will be less important.
- Tax effectiveness
For SMSF members it can be tax effective for their super fund to purchase Life and TPD insurance policies on their behalf rather than purchase them personally. The funds which the SMSF uses to pay the premiums are tax advantaged funds i.e. the contributions have only been taxed at the 15% super contribution rate. To purchase the policies personally the members would have to use after tax dollars.
If the insurance premiums are paid from existing funds in the SMSF the members will not have to find the cashflow to fund the premium payments each year. However if these payments will have an unacceptable impact on the member’s retirement balance the member should be encouraged to increase their superannuation contributions to compensate.
Potential drawbacks with having insurance in your SMSF:
- Cost and Pre-existing Health Conditions
If you are switching your superannuation balance from an existing superannuation fund to your SMSF you should check whether it is possible to maintain your existing insurance benefits by leaving a token balance in your existing fund. The insurance premiums offered by large superannuation funds are group rates and are likely to be cheaper than the individual policies your SMSF can purchase. This is particularly the case if you suffer from any health conditions which may result in exclusions or premium loadings being applied to your SMSF policies. Large super funds sometimes offer minimum levels of cover without medical underwriting and while this amount of cover may not be sufficient in itself it can be used as a base which is topped up with cover in your SMSF
- Super cap limits
In 2014/15 tax advantaged or concessional contributions to super are limited to $30,000 per annum (or $35,000 if aged 49 or over). If you increase super contributions to your SMSF to cover your insurance premium payments you need to remember that this increase will count towards this limit. If this results in you exceeding the concessional limit you will be charged a penalty tax on any excess.
- Reduced Investment Balance
If instead of increasing your contributions to cover the insurance premiums you allow your SMSF to draw down on existing accumulated funds to pay the premium then this will reduce the investment balance remaining to earn a return for your retirement
- Tax payable
Tax can be payable on Life insurance and TPD insurance payouts from super under certain circumstances. To find out more read below the sections on Life insurance and TPD insurance
What do the changes to the rules on what types of insurance super funds can hold ultimately mean for strategies such as cross-insurance?
The rules on what types of insurance super funds could take out changed from 1 July 2014. One strategy put at risk by the new rules was “cross-insurance” – a common approach in funds with limited recourse borrowing arrangements where:
– the fund has more than one member
– it also has a loan
– if Member A dies, the trustees don’t want Member B to be forced to sell the asset (either to pay out a death benefit or because they can no longer support the loan)
– the trustee therefore took out insurance on Member A’s life (and vice versa) with the intention of using any proceeds to effectively pay out the loan or the death benefit or both, rather than adding it to Member A’s balance and paying it to his/ her beneficiaries as part of a death benefit.
It is this last step – not paying the proceeds to Member A’s beneficiaries but rather keeping it in the fund for the long-term benefit of Member B that raised questions.
The new rules on insurance specifically highlight that new insurance policies (ie. those taken out after 1 July 2014) cannot provide for insurance “in relation to a member of the fund unless the insured event is consistent with a condition of release” (SIS Regulation 4.07D). It is easy to see how this provision rules out trauma insurance. Trauma policies pay out on an event such as a heart attack, stroke or other significant illness. While these may well be life-changing events, they are not necessarily covered under the usual superannuation conditions of release – permanent disability or temporary disability.
Cross-insurance was less clear. The cross-insurance arrangement above does describe insurance that is consistent with a condition of release (death), it’s just that on Member A’s death, the proceeds are not used to actually pay out a benefit in relation to Member A.
We, like many others, have been keen for the ATO to express a view on this issue.
Now they have – the ATO considers cross-insurance inconsistent with, and therefore prohibited by, the post 1 July 2014 rules.
What was a little unexpected was that their view on this very important matter affecting many funds with limited recourse borrowing arrangements would be expressed via three lines added to some web content.
Note that this doesn’t mean that policies before 1 July 2014 need to be unwound – they are grandfathered. However, it will be a critical issue for any fund with a large indivisible asset (eg. a property) that effectively covers more than one member’s entitlements. It will be particularly relevant for new limited recourse borrowing arrangements as the premature death of one member may seriously hamper the ability of the remaining member to continue to service the loan.
The annual statistical overview of the SMSF sector each year paints an interesting picture of the dynamics of an ever-growing industry that SMSF professionals and trustees should be aware of.
Outlined below are some interesting SMSF statistics from the report that shed important light on both trustees and professionals within the SMSF sector.
Younger entrant growth continues to rise
With the SMSF sector growing by about 29% between 2010 to 2014, it is the continuing evolution of younger trustees that is starting the shape the future direction of SMSF services. Whilst 82% of members were aged 45 years and older, the sector is now seeing significant growth in the 35-44 age bracket. What is interesting is that more individuals from their mid-30’s are considering SMSFs than ever before.
The ATO has indicated within the report that for the first time, the median age of SMSF members of newly established funds in 2013 was below age 50. Overlaying the average taxable income of SMSF members under 50 ($124,000), you begin to understand how larger amounts of mandated and non-mandated contributions by these individuals are pushing forward these considerations of starting an SMSF earlier than ever before.
A gender shift is occurring
An interesting aspect of the SMSF landscape is gender makeup of trustees. Whilst males have long been represented more within the SMSF sector, there has been a ‘shift’ in the proportion of female members, which now account for 47% of all members. What we are seeing amongst the new fund establishments is strong female population growth, with the quarterly statistics showing more women becoming members in most of the age ranges, with the exclusion of members over 64 years of age.
It will be interesting to follow this statistic within the SMSF sector, in particular the older member demographic. With female life expectancies naturally longer than that of males, one might reasonable suspect that within the next few decades, we will see females as the dominant gender amongst SMSF membership.
The SMSF sector is leading the way in retirement incomes
The post retirement tax concessions continue to swell within the SMSF sector, with 37% of all SMSFs claiming a level of tax exemption within their fund. Whilst only representing a little more than a third of the SMSF population, the representation of total assets in post-retirement is significantly larger. You only need to compare the average member balance of $523,814 against the average pension member balance of $922,554 to gain some perspective of the tax revenue forgone by government as a result of a fund’s tax exemption.
The SMSF sector is leading the way in post-retirement, with more than 93% of the fund members taking benefit payments as an income stream. This is substantially higher than APRA regulated funds, where in some segments continue to face challenges with a lump sum mentality at retirement. For SMSFs, Transition to Retirement (TRIS) has continued to grow (11.4%) as an attractive retirement strategy amongst SMSF members.
On average, SMSF members drawing income streams are taking benefit payments at the rate of 11.7% of the member’s account balance ($108k/$922k). One would naturally consider this amount relatively high in the context of managing longevity, however it is suspected that a proportion of these benefit payments would be contributed back into the SMSF each year through re-contribution.
Why do we continue to see individual trustees growing so fast?
It’s staggering to see individual trustees representing 92% of all newly registered funds in 2014.
Over the three years to 2014, there has been a 2% decline in the number of corporate trustees, even throughout a time where acknowledgement of this type of trustee structure is far superior (through Government review).
It is suspected that this approach to trustee structure may present some interesting challenges in the future, including issues arising under the trustee penalty regime.
The big SMSFs keep getting bigger
The 2012-13 financial year saw positive investment returns for the SMSF sector (10.5%), providing comparative performance returns to that of APRA-regulated funds. Being the fourth year of positive returns since the days of the ‘GFC’, it is interesting to note that the larger the SMSF, the better the return on assets. This is not a reflection of 2012-13, but is consistent in the five years of performance shown within the statistical summary.
The statistics show that 26.9% of larger funds (>$2m) have asset concentration of greater than 80% (one asset class), compared to more than 50% of funds with balances of under $500k. This demonstrates an inability for smaller-sized funds with high-levels of asset concentration to adapt to changing market conditions. In contrast, the larger SMSFs appear able to adapt better and would be more likely to seek advice – a combination that would provide for these higher net worth SMSFs to grow even further.
Making contributions in the year you or your partner turn 65 is a common topic as it seems to cause confusion about how much can be contributed as a concessional (tax-deductible) or non-concessional (non-deductible) amount.
There are some simple steps that can be followed to provide an easy route to understanding what is required.
Can I contribute during my 65th year?
If you are under 65 at the time the contribution is made there is no requirement to satisfy a work test. However, once you reach 65 you must meet a work test at any time during that financial year of at least 40 hours in 30 consecutive days.
1) Santo reaches 65 on 25 December 2014 and has not worked since he was 63. If he wishes to contribute to super he must do it before his 65th birthday as he will not meet the work test this financial year and won’t be able to contribute once he reaches 65.
Alternatively, he could get a job of at least 40 hours in 30 consecutive days and could contribute to the fund at any time during the financial year.
How much can I contribute in my 65th year?
That depends on whether you are claiming a tax deduction for the contributions. Under the rules there is no limit to the amount of concessional or non-concessional contributions you are making to superannuation.
However, if you contribute more than your contribution caps you may have to pay a penalty tax on any excess that you make to the fund.
Contributions that are not tax-deductible are called non-concessional contributions. Providing you are under 65 at the beginning of the financial year you may be able to make non-concessional contributions of up to $540,000 in total to the super fund without paying penalty tax on the excess.
To qualify for the maximum non-concessional contributions of $540,000 in the financial year you turn 65, there are a few rules that apply.
The maximum is called the non-concessional contributions cap and applies if you make non-concessional contributions of more than the standard non-concessional contributions of $180,000 (prior to 1 July 2014 it was $150,000) in any year.
By triggering the higher cap you are able to bring forward the non-concessional contribution for the next two years. This means you are able to make up to $540,000 in contributions at any time during the three-year fixed period.
If you have triggered the higher cap in the previous two financial years (the 2012-13 or 2013-14 financial years) when the higher cap was $450,000, you may be limited to the amount of non-concessional contributions you can make in the financial year you turn 65.
If any non-concessional contribution exceeds your non-concessional contributions cap the fund is required to refund any excess to you and no penalty will apply to that excess.
2) Merry is 65 on 31 December 2014 and wishes to contribute the maximum non-concessional contribution to her super fund. During the past two financial years, she contributed $100,000 in July 2013 and $145,000 in July 2014.
As Merry did not exceed her non-concessional contributions cap in the 2012-13 or 2013-14 financial year, she can trigger the bring-forward rule and make non-concessional contributions of up to $540,000 up until her 65th birthday.
If she meets the work test at any time during the financial year, contributions can be accepted by the fund at any time.
3) Claude will reach 65 in February 2015 and worked for 40 hours in July 2014 just before he retired. He contributed $200,000 in August 2014, $160,000 in November 2014 and will make a non-concessional contribution of $180,000 in March 2015.
As the total of Claude’s non-concessional contributions will not exceed the higher concessional contributions cap, they will not be subject to penalty tax.
4) Rudolph, who is 65 on 31 January 2015, made a non-concessional contribution to super on 1 October 2014 of $600,000 in one amount.
As the non-concessional contribution made by Rudolph exceeds his non-concessional contributions cap, the super rules require any excess to be refunded to him within 30 days. Therefore, the fund will need to refund $60,000 to Rudolph by 31 October.
5) Donna, who is 65 in March 2015, made two contributions to her super fund. One contribution was for $400,000 and the other was for $300,000.
Unlike Rudolph’s situation where one non-concessional contribution was made that exceeded the cap, in Donna’s case, as two contributions each less than the cap were made, there is no requirement under the super rules for an automatic refund.
In Donna’s case, the amount in excess of her non-concessional contributions cap will be subject to a penalty tax.
Once you are 65 or older at the beginning of the financial year you can make non-concessional contributions of up to $180,000 in total without penalty, providing you meet the work test.
Non-concessional contributions can be made to super up until you are 75, providing you meet the work test at some time during the financial year when the contributions have been made.
6) Roger is aged 67 and worked 40 hours during September 2014. He is able to make a non-concessional contribution to superannuation of up to $180,000 without penalty as he has met the work test for the financial year.
You may be able to claim a tax deduction for the contributions in your 65th year. If less than 10 per cent of your adjusted income is earned from employment sources, you may be able to claim up to $35,000 without penalty.
However, once you reach 65 you must meet the work test at any time during the year in which you make the contribution. Just like non-concessional contributions you are unable to make concessional contributions once you have reached 75.
7) Daniel is 65 in March 2015 and earns about $70,000 each year from investments held in his own name. As Daniel does not earn anything from employment-related activities he may be eligible to claim a tax deduction for any contributions he makes to super.
He could contribute up to $35,000 and claim a tax deduction, providing he makes an election that tells the trustee how much he is going to claim.
As Daniel does not meet the work test for the financial year in which he is age 65, he would need to make the contribution prior to reaching age 65 in March 2015.
8) Vicki, who will be 65 in June 2015, earns about $40,000 each year, which includes $10,000 salary and wages from a job as a tourist guide during the Christmas holidays.
As the income she has earned from employment sources is at least 10 per cent of her total income, she will not be able to claim a tax deduction for any contributions she makes to superannuation.
Quote your tax file number
Quoting your tax file number (TFN) is very important if you wish to make personal contributions to super.
If you don’t quote your TFN the fund will not be able to accept any personal contributions to help you build your retirement benefit.
Making it all work
If you turn 65 in a financial year the question of whether you are able to make a contribution to superannuation depends on:
• the amount you wish to contribute;
• whether you wish to claim a tax deduction for all or some of the contribution;
• whether you need to meet a work test during the year; and
• quoting your tax file number.
Joint research from industry association the Financial Services Council (FSC) and investment bank UB has shown that demand has strengthened for annuity and allocated pension products in recent years.
Around two in five respondents (43 per cent) said they are likely to buy a product that provides an income stream from their self-managed superannuation fund (SMSF), while almost one third (30 per cent) were unsure.
The FSC/UBS survey also looked at broader trends in financial services, including in the SMSF sector.
Sixty per cent of SMSFs already have plans or have started planning for retirement.
Increasing demand for products like annuities highlights that trustees are concerned about their investments as they move into retirement, and rightly so. The current swathe of retirees has the memory of the GFC at the forefront of their minds.
By handing over capital to an annuity provider, annuities can offer a simple solution for providing certainty of income.
Annuities can lock the kids out, which is the best way to stop leakage in the form of income. Investors could look at annuities as part of the “post-retirement investment equation”.
If you have a guaranteed income stream, you can take a greater risk with the rest of your portfolio.
Does an investment portfolio before retirement have to be fundamentally different in retirement?
The short answer is that it really depends on what the investment objectives are.
Everyone faces the same market risks throughout their lifetime. Everyone spends money whether they are young or old. What changes is mortality.
The risk when you are young is dying. The risk when you are old is living.
Given this sobering assessment, capital preservation becomes a key investment objective.
While weak markets may be good for young people as it provides them with the opportunity to buy cheap assets, for retirees the best way to create wealth is to not lose it (the wealth, that is!)
We reiterate some caution in making sweeping changes to an investment strategy however.
Investors could look at moving towards a more conservative strategy, but one that has liquidity as well as a sufficient income stream.
It’s also about having that long-term philosophy in place, particularly when taking into content market events like the GFC.
The GFC was a great example of a market slap but how long did it last? Investors may have had capital losses but the dividends and income stream didn’t stop.
Yet many people exited the market in 2009, moving major portions of their portfolios into annuities and missing the market rebound.
Trustees need to think about being prudent and using common sense. The question to ask is “Where do I want to be in five or 10 years and what am I going to do to support myself in retirement?”
The ATO recently confirmed that there are new prohibitions on cross-insurance which could have significant implications for those with limited recourse borrowing arrangements.
In a statement issued last week, the ATO confirmed cross-insurance for any new insurance products is not permitted in light of regulations that came into effect on July 1 this year.
These types of arrangement are prohibited because the insured benefit will not be consistent with a condition of release in respect of the member receiving the benefit, the ATO said.
This could increase the risk of limited recourse borrowing arrangements, given that cross-insurance is used as a risk mitigation strategy.
It’s called cross-insurance because when one member dies or becomes TPD, for example, then the proceeds instead of being added to their account go to the other member.
If the proceeds are just added to the deceased member’s account then it doesn’t provide any liquidity benefits for the fund.
If the proceeds are added to the other member’s account, the surviving member, then the fund can use that money to retire debt. So these type of strategies are commonly used where there’s a limited recourse borrowing arrangement in place.
In light of the statement from the ATO, SMSF practitioners should think about other ways in which their clients’ funds could service a debt in the event that one of the contributors to the fund dies, given that this option no longer seems to be available.
Geoff Saffer, Head of Equities at Australian Stock Report, recently sat down with Steen Jakobsen to discuss the global market and what to expect in 2015.
Steen Jakobsen is the Chief Economist, Saxo Bank A/S. Steen has more than 20 years of experience within the fields of proprietary trading and alternative investment.
Every year, Saxo Bank puts together a number of potential scenarios that may seem “outrageous” today but could come true in the following year.
Late last year Steen predicted oil would fall rapidly to US$80 a barrel, the Aussie dollar would soften significantly, Germany’s economy would struggle and certain US tech companies would plummet.
Be amongst the first to hear what Steen thinks is in store for next year, including;
- Why the RBA could cut rates to as low as 1.5%
- What will drive the AUD/USD in 2015
- Why most investors are too bullish on the US market
- Why investors will be best served piling into fixed interest in early 2015
- The prospect of the market facing a major turning point mid-year
- How to position your portfolio to take advantage of these developments
Using Dividend Reinvestment Plans (DRPs) can be an effective method of growing your super or speeding up wealth accumulation outside super.
When DRPs were originally introduced, some companies offered discounts of 5% or even 10%. These days, generous discounts are rare. Expect to see a discount of around 2.5% or less with many companies offering no discount at all.
Calculating capital gains on DRPs can cause headaches when you go to sell the shares. You need to weigh up whether the administration effort or accounting bills is worth the benefit you would get.
Of course if you or your SMSF owned shares in a company but didn’t want to invest more money in that stock, it would be silly to sign up to that company’s DRP.
How do DRPs work?
Some companies offer their shareholders the opportunity to participate in a DRP. Under these plans, shareholders can choose to use their dividend entitlement to acquire additional shares in the company instead of receiving a cash payment.
Let’s say you (or your SMSF) own 20,000 shares of XTY Limited, which last traded at $1. XYZ now declares a three-cent dividend.
For your 20,000 shares, you are entitled to receive $600 in dividends.
If XYZ offered a DRP and you had selected this as your preferred method of payment, the company would effectively use the $600 to buy more shares for you – giving another 600 shares @ $1 each (DRP purchases also attract no brokerage).
Note, of the 400 or so companies paying dividends, just over half (225 at last count) offered a form of DRP and almost a third of these are ETFs or listed investment companies (LICs).
The Financial System Inquiry’s (FSI) interim report suggests that the days are coming to a close for the use of leverage inside super.
Recent comments by former Prime Minister Paul Keating has fuelled speculation that borrowing in super may be prohibited.
Mr Keating noted a “dramatic acceleration” in investor financing linked to the ability of SMSFs to borrow. He associated this activity with the surge in Australia’s housing prices, particularly in the capital city markets.
“If I was treasurer today, I would be looking very hard at the whole entitlement or availability of debt to SMSFs. They have gearing available to them and, of course, many of them are taking the option of buying residential property.” Mr Keating said.
Since the FSI first sought feedback on restoring the prohibition on direct leverage of borrowing in super, speculation has mounted that the panel will recommend that borrowing in SMSFs be banned.