Playing SMSF Chess

The SMSF investment strategy is like a game of chess and operates under a prescribed set of parameters. These rules have not changed, but more people should be giving this aspect of running their fund greater focus, writes Jason Spits.

Investment strategies have always been a requirement to running an SMSF, but a simple letter sent by the ATO to around 18,000 funds in 2019 redirected attention to this often overlooked and underappreciated obligation.

At the time, there was a range of responses in regard to the letters, which were sent to funds with more than 90 per cent of investments in a single asset or asset class – typically property. These responses induced panic from trustees, as well as concerns the ATO would be assessing the suitability of strategies, something it is not empowered to do, and questions around what makes a compliant investment strategy.

Given the ATO will not mandate what should be included in a strategy and it was already providing plenty of guidance around their creation, the regulator released updated recommendations for trustees outlining its expectations and repeated warnings about using a cookiecutter approach. It also admitted the letterwriting campaign had an impact beyond the funds targeted, with many more trustees reviewing their investment strategy.

Looking back, however, through the mists of COVID-19 and comparing the situation today, the ATO has not taken further action, perhaps because of the impact of the pandemic, but its stance on what is required remains unchanged and is outlined in Superannuation Industry (Supervision) (SIS) Regulation 4.09.

Putting it on paper

One thing that is not mentioned is the requirement the strategy be in writing, a point raised by some critics of the ATO letters.

Heffron managing director Meg Heffron agrees there is no written obligation for an investment strategy to be in writing, but counters by asking if that had to be spelled out under law.

“There have been calls for the law to state it must be in writing, but that would seem self-evident if there are any plans at all to have it included as part of a fund audit,” Heffron says.

“If someone has an SMSF and they plan to communicate their intention to invest in certain assets, it would seem ridiculous not to have that in writing.”

Super Sphere director Belinda Aisbett says the absence of clear directions in the law to have a written strategy is a non-issue from her perspective as an auditor.

“There is a recognition that auditors can’t audit what is in someone’s head and the only obvious way we can be sure they are meeting their obligations regarding an investment strategy is for it to be written,” Aisbett says.

Speaking at a recent SMSF Auditors Association Conference, Advisers Digest founder and SMSF specialist adviser Peter Johnson says the lack of an investment strategy can also be a problem for advisers and accountants when they are being examined by the ATO.

“From your point of view, when you get an audit from the ATO and have a note that says ‘I asked the client if they’ve got a strategy and they said yes, but not in writing’, will the ATO consider you have an adequate audit file?” Johnson says.

“Every client in the country has an adequate investment strategy in their head, but who gets in trouble if the ATO checks your files and look at the investment strategy and you haven’t picked it apart?”

Buying off the shelf

Evolv Super Audits client services director Carol Scholes-Robertson concurs nonwritten investment strategies is not an area of concern and almost every SMSF trustee understands the requirement, but things get looser in underlying documents related to specific investments.

“We do see unwritten arrangements and handshake agreements around leases, particularly in rural areas where they have deep relationships, but not in the investment strategy,” Scholes- Robertson says.

“Where we do have problems with undocumented investment strategies is when people are using off-the-shelf SMSF establishment packages. In these situations the investment strategy is often forgotten, meaning at year end they have a compliance issue with the auditor because they can’t demonstrate an investment strategy has been in place for the year.” She says off-the-shelf investment strategies can create problems, yet their widespread use is due to change in the structure of the SMSF sector.

“We find software-generated, off-theshelf strategies generic and if they don’t match what a trustee is doing, we will push back and request this be reviewed as they lack personal data, expected retirement ages, risk profiles and other things an investment adviser would go into detail,” she says.

“The use of off-the-shelf solutions results from the structure of the industry and what is easy for advisers to do may become difficult if they don’t know the clients or if clients choose to document their own investment strategy.

“Accountants have also shifted out of this space and they were the people that were assisting clients in documenting their thoughts, and that gap hasn’t been filled.”

A place to start

Heffron sees off-the-shelf investment strategies having a place, but only as the starting point to building out an investment strategy and not as the endpoint for trustees.

“Most off-the-shelf templates pay lip service to the things in the law that you have to consider, such as liquidity and diversification, so you wonder if it can ever be a useful tool when every SMSF is different,” she says.

“A template can only go so far and be a guide. The problem was the first templates were quite blunt instruments with tables to be filled in with asset allocation ranges and member details, turning what was a carefully considered decision into something that looks cookie-cutter and doesn’t reflect the strategy.”

While Aisbett does not see off-the-shelf investment strategies as being dangerous for trustees, she highlights the fact they are limited and most trustees will reach those limits as soon as they decide to make changes that are specific to the needs and objectives of their SMSF.

“The reality is a one size does not always fit all. If we have trustees seeking a boilerplate strategy, and they just sign the bottom of it because they think that is all that is needed, they will inevitably run into issues,” she observes.

“When the auditor looks at the strategy and notes it is worded in a particular way and the trustees have done the exact opposite, it is clear the trustees have not given effect to the strategy. We see it when trustees sign a boilerplate strategy that talks about a diverse portfolio with a broad range of assets but the fund only owns property.”

To prevent this, she recommends trustees creating their own strategy should examine whatever templates they have acquired, read them closely and edit the strategy to ensure it aligns with what their SMSF will be doing. In many cases she says this will lead to a good strategy for them.

Making it better

On a positive note, Heffron says, unlike so many other documents in financial services, an investment strategy does not need to be long or overdone, even when complex investments are involved.

However, a strategy will be well served by having some commentary around what it is aiming to achieve, she adds.

“We try to approach it differently and help people pull out of their head the things they have already thought about when setting up a strategy,” she says.

“An example might be why there is a lack of diversification and a large investment in property, which might include questions about having a secure tenant and regular cash flow or an opportunity the trustee could take advantage of because they have particular expertise in this area.

“There are a number of elements people often take into account, whether they know it or not, in making decisions as to where to focus their asset allocations and what we are trying to do is create space for the trustee to articulate the strategy they already have.”

Following the ATO letters of 2019, the regulator discouraged the practice of stipulating an SMSF could have anywhere between 0 and 100 per cent of its investments in any given asset class and suggested the use of specific ranges that were more likely to be held by the fund in the coming year.

Conversely, Johnson says investment strategies should not go to the other extreme and contain allocation bands that are too small or exact to allow any flexibility within the portfolio.

“Remember that you don’t want to go too tight and state things like the strategy will include Australian shares at 23 per cent as those types of details are not necessary,” he advises.

“A strategy that runs through buying a property and maintaining enough cash to cover cash-flow requirements for the fund, as well as allows for the acquisition of some Australian shares, sounds like it is considering the overall asset mix rather than ‘we will do what we want whenever we want to’.”

DBA Lawyers special counsel Bryce Figot says trustees still unsure of what to do can use regulation 4.09 of the SIS Regulations and guidance from the ATO to tick the necessary boxes, but he cautions consideration must be given to the life insurance needs of members.

“The big issue when using something off the shelf for advisers is the need to think about insurance, and if an off-the-shelf template adds a line stating the members should have insurance, and someone dies or is injured and there is no insurance, that adviser could be liable,” he warns.

“I haven’t seen it happen in practice, but it certainly does not require much imagination to see how it could.”

Carrot and stick

As a consequence of the ATO’s shot across the bow, auditors are now expected to have a greater role in identifying and addressing problems with an investment strategy, a view reinforced by the Ryan Wealth Holdings Pty Ltd v Baumgartner case, in which the auditor was found liable for failing to detect irregularities in the investment strategy.

In fact, Scholes-Robertson sees this as the chief outcome of the exercise. Further, she suggests the carrot is being held out to trustees to encourage them to change, but auditors are getting the pointy end of the stick if they fail to observe and correct any problems.

“As an auditor it is really difficult because the ATO has put us in a tricky position by telling trustees their auditor will be asking how they have addressed any issues with a strategy,” she says.

“We had to work out what our audit response was going to be and ask trustees to specifically articulate what the ATO has asked them to do. But it has not really changed the things the regulator was attempting to address in terms of a change of behaviour.”

Despite this, Evolv client services senior manager Blair Hornick says auditors have other tools they can use to encourage compliance with investment strategy standards apart from a management letter or an auditor contravention report (ACR), and calling upon the skill and influence of other SMSF professionals is a central way to improve trustee behaviour.

Hornick explains the use of general language in newsletters, particularly around specific asset classes and investments, provides broad information that can be built upon by accountants and advisers.

“Some of the best leverage we have in terms of influencing behaviour are management letters and ACRs for individual trustee issues, but in terms of influencing and educating trustees we do that indirectly via our efforts and that of accountants and advisers,” he reveals.

“We also make it very specific around particular issues and we will talk about unlisted investments, for example, and how they fit within a compliance framework so we can be more specific about areas for trustees to focus on.”

Moving forward by looking back

It has been close to three years since the ATO raised its investment strategy concerns, so does this mean we should be seeing an improvement in this area?

Aisbett says this may not be the best way to assess where the sector should be and instead the regulator’s perceived intent needs to be taken into account.

“What the ATO has tried to do, which I think is helpful, is remind trustees that this is an obligation they need to look at and that there are certain things needing to be addressed on an ongoing basis,” she notes.

“If you read the ATO guidance on investment strategies, it is not designed for SMSF professionals. It is for trustees and as soon as they incorporate that guidance in their investment strategy the audit process is really easy and it becomes a checking process.

“I joke with people that if you run an SMSF, your sole goal, besides providing for retirement, should be to make the auditor happy and you’ll achieve this with an investment strategy that is simple to follow and really clear about what is required.”