Avoid the seven sins of new SMSFs

Self-managed super funds (SMSFs) are still opening at the rate of 2,200-plus a month, as the sector truly consolidates its position as the most popular form of superannuation. Total fund numbers have reached almost 450,000 – a jump of 65% over the past seven years.

However, the burgeoning SMSF numbers inevitably mean that a proportion is launched with serious flaws, which may bring costly and time-wasting troubles for the members, and even threaten the funds’ future.

In reality, many people who set up self-managed super funds might be better leaving their retirement savings in large public-offer funds.

The issue of whether to open a self-managed fund is a key consideration for many SME owners, considering that almost 40% of SMSF members are self-employed or derive their income from an unlisted business or partnership.

Seven of the biggest sins made by new SMSF members are:

1. Opening a fund with an insufficient initial balance

Unless you have realistic plans to rapidly increase a low total balance – not just wild dreams – stay away from SMSFs.

Broadly, much of the super industry considers that a self-managed fund is not financially feasible until the combined value of member balances reaches at least $200,000; and that’s very much on the low side. Some super specialists, with strong justification, advocate much higher minimum total asset values.

When calculating whether a SMSF is financially feasible given its total combined member balances, don’t forget to include expected investment and advisory costs, in addition to administration charges, in your calculations.

As a ballpark indication, a professional SMSF administration firm typically charges a fund about $2,000 a year for administration services alone; this equates to 1% of funds under management for a $200,000 fund. (Administration costs vary, above and below $2,000, and are higher for funds with many investments.)

By contrast, heavyweight public-offer fund AustralianSuper charges members an administration fee of $1.50 a week plus 0.6% of balances to cover investment management costs for its default “balanced” portfolio. And another large public-offer fund, First State Super, has markedly cheaper investment management costs of 0.24% for its “diversified” portfolio plus $1 a week for administration.

A key message is that SMSFs with large total balances can be cheaper, often much cheaper, than a large fund – depending upon the circumstances.

2. Opening a fund with a low balance AND low member incomes

This is truly a double jeopardy position for new self-managed funds. Low-member incomes typically make it much harder to rapidly boost a fund’s total balance – unless the members still have big amounts to rollover into their new SMSFs from large funds. Of course, some new SMSF members may be preparing to make large contributions, perhaps from inheritances.

Recently published ATO statistics show that more than a quarter of self-managed fund members had taxable incomes under $26,000 as at June 2010, although the average member income is much higher.

3. Opening a fund with little knowledge of even the basic SMSF rules

This is really asking for trouble.

The ATO, as an SMSF regulator, is taking an increasing stronger stance against wayward fund trustees. One of the toughest actions the ATO can take is to formally remove a fund’s complying status, which can lead to the fund losing up to almost half of its assets in tax.

The assets of a fund that has been declared non-compliant are taxed at the highest marginal tax rate, apart from any undeducted contributions (after-tax or non-concessional contributions). In 2009-10, the ATO made 185 funds non-complying which doesn’t seem many at first glance but is a dramatic increase from earlier years.

The main reasons that these funds lost their complying status last financial year were providing loans to members (such loans are strictly barred); illegally gaining early release of super; refusing to lodge regulatory returns; or overshooting the in-house asset limit.

Under the in-house asset rules, a fund must not invest or lease more than 5% of its assets with related parties of the fund (including members).The Cooper review has recommended the barring of all in-house assets.

New trustees should really understand the basic rules and treat transactions with members, which are not banned in all circumstances, with extreme caution. A smart idea is for fund trustees to voluntarily have a general policy of not having any related-party transactions – and only breaking that policy on rare occasions, and only if the transaction is strictly within super law.

4. Drawing on your SMSF to prop up your business during a difficult trading time

Under superannuation law, funds are barred from providing financial assistance to members or the relative of a member.

You may be justifiably confident that your business is only experiencing temporary troubles and will soon get back on track. But it is a dangerous practice to regard your self-managed fund as a ready source for emergency money. (Apart from the total bar on lending to members there are extremely limited restrictions on lending to “related parties” of an SMSF which include entities controlled or majority owned by a members or their relatives.)

5. Arranging for your SMSF to own your business premises as its main asset… without thinking about what may go wrong

At best, arranging for your self-managed fund to own your business premises is an effective strategy. And it is extremely popular among SME owners. But consider the negatives and positives.

The positives include that the fund will pay only 15% tax on the commercial rent paid by your business for use of the premises. And if the premises are eventually sold after your fund has begun to pay a pension(s), no capital gains tax is payable provided the premises is one of the assets backing the payment of the pension.

A difficulty could arise if one of the members of, say, a two-person fund were to die and the fund had to pay out superannuation death benefits. This could lead to the rushed sale of the business premises for a below-market price or in a weak market. (Under superannuation law, a fund must payout a deceased member’s death benefits; the amounts cannot remain in the fund.)

Another consequence of a sale to pay death (or retirement) benefits is the risk that the family business will lose its use of the premises. This may damage the business.

A strategy to potentially avoid a forced sale of business premises to pay benefits is for a SMSF to progressively build up enough liquid assets such as listed shares, bonds and cash. These liquid assets may be enough to pay retirement or death benefits of older members.

6. Failing to plan for the death or serious illness of a member

Proper planning is particularly crucial if your fund is a typical husband-and-wife arrangement with one member making most of the decisions. The death or illness of the dominant member could wreak havoc on the fund’s affairs.

Strategies to help overcome this difficulty include ensuring both spouses have some knowledge of the fund’s investments and aiming to simplify the fund’s investments as members grow older. This would make it easier for the less-involved member to take over the fund.

Other strategies include both members having an enduring power of attorney which allows the attorney to take over as a trustee of the fund or director of the corporate trustee if one of the members becomes old, seriously ill or loses mental capacity. (Check the legislation regarding enduring powers of attorney in your state; provisions can vary state to state.)

Some older members encourage their adult children to join their fund so the death or illness of a member may be less detrimental to the fund’s operation.

For instance, allowing children to join their parents’ self-managed fund may work well if they are in business together. But there can be some drawbacks including the fact that other people become involved in your financial affairs.

7. Opening a SMSF without checking insurance cover

This is most often a danger when transferring your super from a large fund with satisfactory death and permanent disability cover which did not require members to undergo health checks. You may not be able to obtain the same level of cover for the same price through your SMSF, particularly if your health is not too good.

A smart strategy is to leave enough money in your existing fund to retain your life and life disability insurance while shopping for the best insurance deal for your new SMSF.