5 smart steps for DIY super trustees

At a time of high volatility and uncertainty in credit and investment markets, expect a flood of new geared products for DIY super, writes MICHAEL LAURENCE. Fund trustees should take extreme care.

By Michael Laurence

DIY super fund trustees need to understand what’s at stake with gearing a DIY fund – and that there are smarter steps to take to boost your fund.

Trustees of self-managed super funds shouldn’t sign up for any of the new gearing products being promoted to their funds without first understanding a fundamental fact. They may be putting a huge chunk of their retirement savings on the line. 

These products can carry a level of risk that may not be readily recognised, particularly by inexperienced fund trustees.

The bottom-line is that a sharp fall in the value of a geared asset could wipe out a significant proportion of the fund members’ retirement savings – depending on the circumstances, including the level of borrowing and the overall diversity of a fund’s investments. (See our top five tips on the following pages.)

Since the superannuation law was amended in September last year to unequivocally permit self-managed funds to borrow to invest under stringent conditions, lawyers, superannuation specialists and financial institutions have been designing new gearing products and facilities targeting these funds.

The amendments are an exception to the long-standing and remaining general ban on borrowing to invest by self-managed funds.

Expect gearing products to come on to the market in growing numbers over the next few months to enable self-managed funds to gear into residential and commercial property, listed shares, and managed investment funds.

For instance, the Macquarie Bank last week released a product called Property Lever for self-managed funds to gear into the residential properties of their choice. And the investment bank intends to launch other specialist gearing products aimed at these funds.

Make no mistake. The new gearing products may open some exciting opportunities for self-managed funds whose trustees invest for the long-term in top-quality, well-priced assets.

As I have written previously in my SmartCompany column, smaller business owners, for example, can use the new gearing opportunities to enable their self-managed funds to buy their business premises, which can then be rented back to their businesses for commercial rates.

But I cannot overemphasise that fund trustees should fully comprehend the extent of risks involved before entering these arrangements, and consider gaining quality investment and superannuation advice from quality licensed advisers.

As Sydney tax and superannuation lawyer Robert Richards says: “Any gearing [whether inside or outside a super fund] is an additional risk. It’s the old story; gearing can maximise profits but it can maximise losses.”

And Dean Firth, executive director of Macquarie Relationship Banking, told SmartCompany: “Aggressive gearing shouldn’t be in a super fund. At the end of the day, it is retirement money.”

Firth points out that Macquarie’s Property Lever product will lend a maximum of 55% of a property’s value, and the total value of a geared property cannot exceed 125% of a fund’s total value. In other words, the level of gearing is conservative and a super fund must also hold other assets.

Without doubt, the issue of gearing by self-managed funds will become an increasingly controversial issue in the coming months, particularly given the turmoil in credit and equity markets.

Here are my five tips for trustees of self-managed funds who are considering gearing an investment:

1. Thoroughly understand the new rules on borrowing: Under the amendments to super law, DIY funds can borrow to invest provided the geared assets are held in trust until the final loan payment is made. Most significantly, a lender cannot make a claim against any other fund assets of the super fund in the event of a default.

The tax office, as regulator of self-managed super, has signaled its intention to keep a close watch for any non-compliance by funds that gear investments under the new provisions. And the Australian Securities and Investments Commission (ASIC) warns that it will check whether new gearing products are adequately disclosing the level of risks involved.

2. Know what’s at stake in the event of default by your fund: Many trustees may gain unwarranted comfort from the provision in the super amendments stipulating that a lender cannot make a claim against the other assets of the fund in the event of default.

At worst, a fund that defaults following the failure of an investment could lose its deposit (that might also be termed as an initial capital contribution) plus any capital repayments made to the time of the default. This means a huge amount of fund savings could be at stake.

A lender is likely to require the fund to have made a large deposit of perhaps up to, say, 45% of the asset’s value. That deposit will have come out of fund assets!

Typically in the event of default, a lender would sell the geared asset and refund any surplus to the fund. In practice, it would be very rare for the value of a geared asset to completely be wiped out or even fall by 50%, causing a fund to lose anything close to an entire, substantial deposit.

3. Select assets for gearing with extreme care: Gearing into poor quality assets is asking for trouble.

4. Ensure your fund is appropriately diversified for its membership: Some DIY fund trustees decide to invest all of their fund’s capital in a single piece of geared or ungeared real estate.

Certainly, such decisions may be considered appropriate in some cases, given the members’ other super and non-super investments.

However single-asset DIY funds are solely dependent for their investment success on the fate of that single asset. This unquestionably involves taking on considerably more risk for the fund than with a diversified investment portfolio, and all fund members should comprehend the risks involved.

As well, fund trustees should never overlook the responsibility of their funds to pay benefits upon members’ retirement or death. If a fund owns or is buying a single costly asset, the payment of member benefits whenever necessary can be difficult. Real estate, of course, cannot always be quickly sold for a reasonable price.

5. Be extra cautious about taking on debt at this time: The change in superannuation law just happens to coincide with the turmoil in investment and credit markets from the sub-prime mortgage crisis in the US.

Many investors are choosing to cut back on debt until the investment outlook becomes more positive. This caution makes sense – particularly for DIY super funds that are looking after their members’ retirement savings.

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