It is therefore critical to ensure that in making investments on behalf of the fund no diminution of capital takes place. Many people who are concerned that they have insufficient funds accumulated in their funds take huge risks when investing by attempting to gain excessive returns to make up that perceived shortfall and all they achieve is a greater shortfall by the loss of the invested funds or at least a large part thereof.
Understanding the real risks attached any form of investment is essential if one is going to achieve a secure return from that investment into the future.
Whilst the majority of Australian SMSFs have in their portfolios Equity portfolios and Managed Fund investments very few have the maturity and sophistication of retirement portfolios in Europe and the United States.
Here’s an example comparing Australian investments on the left with US investment categories on the right. Noticed the small orange portion. This image is repeated again and again comparing Australia with most OECD countries.
(Data is from OECD Pension Markets in focus 2016)
These portfolios tend to be structured based on their long term experience of limiting risk and providing well-structured retirement incomes.
Some of the products which the investment managers in those markets studiously avoid include:
1. High risk products dressed up as secure investments
Many of these financial products are much riskier than you were led to believe it would be, many are sold by unlicensed people without a proper explanation of the risks and your SMSF is not eligible for compensation if things go wrong.
Many of these products are property development projects which cannot be funded through normal bank mortgages and debt structures and see the SMSF market as an easy target for 10-15% interest yields in a market of low interest rates.
The security they offer tends to rank behind that of their primary lender, in particular, if it is a bank and often proves to be worth much less than the principal sum in the event of a default. One must remember when investing that “the higher the reward…the higher the risk” so carefully assess the likelihood of receiving both the return on the investment and the return of the capital invested.
2. High risk equity stocks
Speculative mining, tech and development companies often carry as much risk of some of the high risk products referred to above.
It is quite common to see SMSF investors take up shares in speculative mining companies which are raising money for exploration.
Remember that for your investment to be worth the risk you are taking it will need to rise in value considerably, find a commercial mining resource, have the funding available to exploit that resource and have a committed mining team capable of delivering the results.
It is of no value to you if the company cannot commercially sustain itself as it will then have to go back to the market for capital and if the resource is not significant that next capital raising might well be at a price less than you paid for your shares.
3. A holiday home
It was a common occurrence in years gone by to see SMSFs with a lovely holiday home by the beach or a “Pitt Street” farm sitting amongst the asset portfolio and whilst that has in more recent times become less prevalent it still exists in some funds. “Why not?” some may ask. The most important aspect of the answer to that question is that it breaches the “sole purpose” test.
The assets in the SMSF are supposed to be for the sole purpose of providing the beneficiaries with retirement benefits not providing them with holiday accommodation during their working lives.
In any case, a holiday home may or may not provide the best income and capital growth for your retirement so you should look to assets which can securely and safely achieve that objective.
4. Development property
Many accountants and advisors look to establish “syndicates of investors” to provide capital to property developers or to provide capital for the syndicates own property development. Before investing in one of these syndicates the Trustees must consider whether the Syndicate, which may be in the form of a unit trust or company, is a complying investment for the purposes of an SMSF. In many cases, you will find that such investments are not complying investments.
In addition, many people have invested (and have been encouraged to invest) in development properties in the name of the fund. Often these developments involve the Trustee in trading activities and also result in the SMSF being in breach of the “sole purpose” test.
If your SMSF is investing in property or property syndicates obtain advice from an expert before committing to such an investment to ensure that the activity does not put the fund in breach as the consequences of the fund becoming “non-complying” can be a 47% tax rate.
Property development is an area of high risk and, in any case, the Trustees of an SMSF investing in property should carefully consider the Investment Strategy of the SMSF and whether it is appropriate to risk the proposed proportion of the assets in the SMSF in such an investment.
5. Property assets that are not liquid
Investments by SMSFs in undeveloped and untenanted property such as “greenfields” land sites and country farms are also questionable in that they are generally not meeting the “sole purpose” test as they are more often than not failing to provide income to meet the retirement needs of the beneficiaries of the fund.
Investing in property as a tactic to meet the Investment Strategy of an SMSF must be considered in the wider context of the overall asset portfolio and income requirements of the beneficiaries of the fund.
The Trustee must ensure that the fund has sufficient liquidity to meet the income requirements of the beneficiaries and the overall pension and administration obligations of the fund.
When considering whether the fund should invest in property assets it is advisable to assess the beneficiaries wider asset portfolio in its entirety to determine whether the asset mix of the fund should include property as the wiser heads in the established markets in Europe and the United States clearly advocate portfolios which include equities, fixed (and variable) interest (IBDs and corporate bonds), property (managed funds and direct) in such proportions as reflect the age of the beneficiary and the greater focus on the fixed (and variable) interest component as age of the beneficiary increases.
We’re happy to discuss investment options with you and your financial advisor. Please contact us and set up a time to talk.