ATO Non-Diversification Warning Letters to Self Managed Super Funds Holding 90% of their Wealth in a Single Asset or Asset Class

22 November 2019

Thousands of Self Managed Super Funds (SMSFs) in recent months have received a letter from the Australian Taxation Office if according to ATO records, the fund held more than 90% of its assets in a single asset or a single asset class.

Diversification is a key requirement under regulation 4.09 of the Superannuation Industry (Supervision) Act (SISA).

Investment Strategy... Investment Strategy... Investment Strategy

If you as a Trustee of an SMSF, have received one of these letters, you have no doubt called your accountant or advisor in panic mode to find a solution. Your advisor will, of course, ask you, the Trustee, to review the fund's "Investment Strategy" and to ensure that non-diversification is adequately covered within this document.

We have found that a majority of the letters have been received by Trustees who have invested in a single property or property asset class where the investment has been purchased under a limited recourse borrowing arrangement. In other instances, SMSFs with 90% of investments in a single asset class have also received these letters.

If an SMSF has received one of these letters, trustees are required to forward their Fund's investment strategy to the SMSF auditor providing evidence of how they consider their investment strategy has met the following requirements:

Diversification of Fund Investments - Trustees should almost always consider investing in a diverse pool of investments since not only is diversification a key requirement under regulation 4.09 but also an effective investment strategy and tool.

If an SMSF Trustee decides to invest in a single asset class, the investment strategy should clearly address the risks associated with such non-diversification and the processes laid down by the trustee for adequate management of such risks.

It may be that diversification is achieved within a single asset class such as Listed Australian shares where the Trustee chooses investments in Listed Shares. Hybrids and Exchange Traded Funds across a wide industry base.

A fund trustee with significant experience in the property market may choose to have a mix of commercial properties across the retail, commercial and office sector and could have a diversified property portfolio offering significant returns.

The trustee may choose to maintain low cash reserves if most of the assets held in the single asset class are traded on an exchange and are liquid. Yet another reason could be holding less cash reserves due to low-interest rates.

The above are a few scenarios from many that could result in a significant percentage of the portfolio being invested in a single asset class but the key is to document the reasons of non-diversification in the investment strategy.

A funny thought comes to mind as to whether trustees will receive letters in future for over diversification, This scenario takes place when the number of investments in a portfolio exceeds the point where the marginal loss of expected return is greater than the marginal benefit of reduced risk. In simple language, when individual investments are added to a portfolio, each new investment lowers risk but also lowers the expected return. We do hope the ATO understands that there is also an over diversification risk to a fund's portfolio and not just a non-diversification risk.

Another event that is not captured by the ATO from SMSF Annual Returns is the fact that a fund may be non-diversified even though it reports investments in different classes. An example would be a fund reporting 50% "Non-residential properties", 41% "Unlisted Unit Trusts" and 9% cash. If the 41% is invested in unlisted commercial property trusts, the ATO would fail to recognise that the fund has invested 91% in a single asset class.

Given the above, if you are a trustee who is just too scared to invest in anything but Term Deposits and cash and are non-diversified due to lack of experience in the markets, seriously consider moving your funds to Third Party or industry superannuation funds where professionals can generate better returns for your retirement funds rather than letting funds in your SMSF erode over time with inflation. Alternatively, place the SMSF funds with licensed advisors who can assist in securing a diverse pool of good investments and provide better returns over time.

Making, Holding, Realising, and the likely return from their fund investments relating to their retirement objectives and expected cash flow requirements - An investment strategy should address why the trustees chose the single asset or asset class and how the return on investment from the single asset or asset class over time will meet their retirement cash flows. A historical or future expected return comparison from a single asset class to a moderately diversified portfolio can also be documented and considered to provide justification for the non-diversification route taken by the trustees.

Trustees may be comfortable investing in a particular asset class due to personal/business knowledge, experience or circumstance. An example would be Medical General Practitioners investing in Medical Centre real property. During their working life their medical practice leases the property from their SMSF and pays market rent to the SMSF. At retirement the property could be sold for a significant return or alternatively the medical practice successor/buyer may continue to pay the rental returns to the SMSF providing long term secured revenue inflows to the fund.

In this scenario, although the funds are invested in one asset class, the asset(s) may provide secured long term returns at a better rate than what could be achieved within other asset classes while minimising the risk associated with continued returns due to self management.

The investment strategy in this instance should therefore address the mitigation of non-diversification risk by taking into consideration the initial investment, fund liquidity, proposed holding period, realisation of profits and/or future revenue providing the total return on investment from the asset/asset class. If Limited recourse borrowings are considered, cashflow budgeting also needs to be carefully prepared and documented in the investment strategy for the borrowing term.

Liquidity & Expected Cash Flow Requirements - Trustees should note that the ATO only gets a 30 June snapshot of the Asset & Liability position of the fund. It is common practice for Trustees to pay off borrowings and maintain low cash reserves in order to minimise interest costs. If the fund is in pension phase, trustees frequently pay large retirement benefits over the prescribed minimum in order to fund lifestyle, medical and personal commitments before the end of the financial year. Both these scenarios can very easily drop cash reserves below 10% and if the the remainder is invested in one asset or asset class, the annual return lodged with the ATO will show more than 90% held in one asset class and may trigger a non-diversification ATO letter.

The investment strategy should therefore clearly specify how the liquidity and cash flows of the fund are adequately managed. A cash flow budget matching inflows such as contributions, fund revenue to outflows such as fund costs, taxes and loan repayments should provide a good indication of the level of liquidity required.

Funds with relatively young members could document that there is a relatively long period of investment in the accumulation phase before retirement payments will be required and during this time the strategy is to maximise borrowing repayments in order to minimise long term interest costs. If the fund is in pension mode, the investment strategy should address how the fund will manage the required mimimum pension payments required from fund cash flows while covering fund administration costs and liabilities

Whether insurance cover should be held for one or more members - Adequate Insurance should be maintained within the fund for members in order to cover existing or future liabilities such as repayment of borrowings in the event of death or disability of the member(s). If insurance is not maintained with the fund, reasons should be adequately stated in the investment strategy. Possible reasons could be members hold external insurance policies, members are in pension phase with significant asset base and minimal liabilities/costs, members hold significant levels of external assets or member's are able to make future contributions to the fund to meet fund costs and liabilities if required (subject of course to statutory contribution caps). Document the level of insurance or reasons for not holding insurance in your SMSF investment strategy.

In summary, if you are the Trustee of an SMSF that has received a letter from the ATO, this is a great opportunity to review your investment strategy and address any shortcomings or inconsistencies within the strategy relating to non-diversification.

The above does not constitute personal or general financial advice. If steps need to be taken to address your specific SMSF strategy, do contact your licensed SMSF advisor so as to maintain the compliant status of your fund.