Ethics and self-managed super funds

03 Jun 2019

From AdviserVoice - This Ethics article is proudly brought to you by GSFM

There’s an additional layer of factors to consider when recommending the establishment of an SMSF.

Since the official introduction of self-managed superannuation funds (SMSFs) in 1999, they have become a significant part of Australia’s $2.6 trillion^[1] superannuation sector. At the end of 2018, with assets worth $728 billion, SMSFs represented 27 percent of the total super sector. Bound by an array of rules and regulations, this article, sponsored by GSFM Pty Ltd, examines the super sector and ethical considerations for advisers recommending SMSFs to clients.

An SMSF is a privately run superannuation fund established for the sole purpose of providing retirement benefits to its members. SMSFs can have between one and four members (increasing to six from 1 July 2019), who must also be trustees of their fund. The trustees are responsible for all decisions made about the fund and compliance with relevant laws, of which there are many.

Unlike industry or retail superannuation funds, SMSFs are not regulated by the Australian Prudential Regulation Authority (APRA); instead, SMSFs are regulated by the Australian Taxation Office (ATO). The law requires all SMSF trustees to have their financial accounts and their compliance with the Superannuation Industry (Supervision) Act 1993 (SIS Act) audited annually by an approved auditor.

ASIC’s role in relation to SMSFs is to regulate the service providers; the advisers, auditors, and providers of products and services to SMSFs.

Establishing an SMSF

A 2018 review of the sector by ASIC^[2] found two key motivations for establishing an SMSF. Firstly, individuals wishing to gain control over their investments and secondly – and a more recent phenomena – to use SMSFs as a vehicle for investing in residential property. Since the emergence of the SMSF sector in 1999, there has been steady growth in the sector; as illustrated in figure one, the trend has continued over the past six years, with strong growth in both the total number of SMSFs and the total number of SMSF members.

According to the ASIC review, SMSF trustees are more likely to use financial advice than other investors. Research^[3] undertaken in 2017 found the main reasons for SMSF members to use financial advice were:

The perceived advantages of tailored advice
The perceived complexities of tax and administrative procedures
To access new or inaccessible investments

As any adviser who’s had exposure to SMSFs knows, there are numerous rules, regulations, costs and a few rules of thumb when it comes to setting up an SMSF. It involves creating a trust with either individual or corporate trustees who are responsible for managing the trust’s assets. Something many prospective trustees don’t realise is that they are responsible for ensuring their SMSF’s ongoing compliance with super and tax legislation; this includes the annual audit, as well as financial reporting and taxation obligations to the ATO.

It’s critically important that clients understand their responsibilities if they decide to set up an SMSF; they are personally liable for all decisions made by the fund, including following any advice you or other service providers give them. It is, therefore, imperative to ensure that your clients understand both their responsibilities and all advice they are given.

There are eligibility criteria for becoming an SMSF member – and therefore a trustee. In the first instance, a person must consent to becoming a trustee and accept their responsibilities by signing a trustee declaration.

SMSF members/trustees cannot:

Be a registered bankrupt
Have previously been disqualified as an SMSF trustee by a court, the ATO or ASIC
Have an employer/employee relationship with another fund member (unless they are related).

Minors (under the age of 18) can become members of an SMSF provided they are represented by a trustee who agrees to act on their behalf, such as a parent or guardian. (Source: ASIC MoneySmart)

Ensuring your clients understand their obligations is important; an SMSF trustee can be penalised for non-compliance in several ways:

Their fund losing its concessional tax treatment
Being disqualified from their role as trustee – this means they can no longer be members of the SMSF and they are unable to start a new one
Fines or imprisonment, depending on the seriousness of the breach.

Despite the number of rules and regulations, as well as serious penalties for non-compliance, ASIC’s 2018 review found a large number of consumers did not fully understand what is involved with running an SMSF, the time commitment required and the role of advisers and other SMSF experts.

Costs are an important consideration; set up costs and annual running expenses can be high. It’s generally considered that it’s not cost effective to establish and operate an SMSF where there is a small balance.

One component of the ASIC review was an online survey of 457 consumers who had established an SMSF. The results of the survey showed:

38% of respondents found running an SMSF more time consuming than expected
32% found it more expensive than expected
33% did not know the law required an SMSF to have an investment strategy
30% of members had no arrangements in place for their SMSF if something happened to them
29% mistakenly believed that SMSFs had the same level of protection as prudentially regulated superannuation funds in the event of fraud
19% of members did not consider their insurance needs when setting up an SMSF.

It is important that those financial advisers recommending SMSFs and helping members with aspects of SMSF management clearly articulate the benefits, disadvantages, regulatory requirements and costs associated with managing an SMSF.

SMSFs versus other superannuation funds

When determining whether an SMSF is appropriate for a client, an adviser needs to consider their existing super fund and other retail or industry super funds that may be better placed for their individual circumstances. There are several key differences between SMSFs and APRA regulated super funds that clients should be aware of before deciding to establish an SMSF:

SMSF members are the trustees of their own fund – as trustees, the client is legally responsible for managing the fund and making sure it complies with superannuation and tax laws. Industry, retail and corporate funds typically have professional, licensed trustees who take on the responsibility for legal compliance.
SMSF trustees are responsible for their fund’s investment strategy and make all investment decisions, even if those decisions are advised by professionals. Members of public super funds have some degree of choice when it comes to broad asset allocation, however each funds’ trustees make – and are responsible for – asset allocation and investment decisions.
SMSFs can only have a limited number of members – currently SMSFs can have up to four members; to increase to six from 1 July 2019. This can limit the number or type of assets the members can invest in. For example, a public super fund with hundreds of members has the scale to invest in private equity or direct infrastructure, investments that generally require a significant investment amount.
SMSFs are regulated by the ATO and ASIC, while industry, retail and corporate funds are regulated by APRA.
Importantly, members of public funds have access to the Superannuation Complaints Tribunal to resolve disputes and are eligible for a government compensation scheme in the event of trustee misconduct or fraud. SMSF members have no such recourse.

Financial advice and SMSFs

Trustees manage SMSF funds by making investment decisions; even if those decisions are guided by an advice professional, the legal responsibility for those decisions rests with the fund’s members.

It’s also a legal requirement for each SMSF to have a documented investment strategy. This investment strategy should satisfy the sole purpose test and be used to guide trustee decision-making. To satisfy the sole purpose test, an SMSF needs to be maintained for the sole purpose of providing retirement benefits to its members, or to their dependants if a member dies before retirement. Importantly, clients need to understand the sole purpose test and the potential ramifications of breaching it.

Important factors to consider when working with clients to develop an SMSF investment strategy include:

The individual characteristics of the fund’s members, such as age, current financial situation, risk profile and investment objectives
A tailored strategy that will meet the members’ retirement objectives
An appropriate asset allocation to meet these objectives
Appropriate implementation of the fund’s asset allocation, including consideration of fees and expenses
How easily the fund’s assets can be converted to cash to pay future member benefits when members are retired
The insurance needs of the fund’s members.

As with any investment, there are positives and negatives when it comes to SMSFs; the importance of each will vary from person to person, depending on their individual circumstances.

ASIC’s 2018 survey found that many SMSF members did not understand the downside risks when establishing an SMSF. Although ASIC acknowledged the difficulty in assessing the long-term financial impact of setting up an SMSF, they found that 10 percent of clients surveyed were at risk of being ‘significantly worse off’ in retirement as a result of using an SMSF rather than an APRA regulated super fund.

Their concerns were based on three key factors, singly or in combination:

The size of the SMSF
The age of members
The level of gearing within the fund.

ASIC found a further 19 percent of SMSF members surveyed were at increased risk of ‘suffering financial detriment’ as a result of following the advice to establish an SMSF. ASIC’s concerns were based the assets of the funds being invested in a single asset class – property – which appeared to pose an unnecessary risk due to lack of diversification.

Best interests test

Financial advisers have a critically important role to play in ensuring that only those consumers for whom an SMSF is suitable establish an SMSF. That’s the first hurdle, but not last, for meeting the best interests test. Advisers also need to consider factors such as:

The client’s existing superannuation fund/s and their appropriateness vis-a-vie an SMSF
Consideration and comparison of suitable alternative strategies that would meet clients’ needs
The fund members’ knowledge and understanding of their legal obligations as trustee
The fund members’ knowledge and understanding of fundamental investment principles
Whether the client has the time required to administer an SMSF, including record keeping
Whether an SMSF is best placed to meet the clients’ retirement objectives
Whether the amount used to establish the SMSF is appropriate given the establishment and ongoing costs
The level of contributions to be made going forward
The types and level of insurance cover required by the members
Estate planning considerations in the event of the death of a member.

Referring again to ASIC’s 2018 review of SMSF files, the regulator found that the advice provider did not demonstrate compliance with the best interests duty and related obligations in 62 percent of cases. The main areas that led to files being non-compliant were where the adviser had not demonstrated they had sufficiently researched and considered the client’s existing financial products and/or based all judgements and recommendations on the clients’ relevant circumstances.

Given the exacting requirements and changing legislative environment that surrounds the SMSF sector, advisers providing advice on SMSFs must maintain a high level of relevant knowledge and skills; to comply with standard 10 of FASEA’s code of ethics, advice should not be provided in any area unless you have the necessary skills and competencies to do so.

Case studies

The following case studies are based on real events; however the names of people and organisations have been changed, and some details altered. The case studies have been drawn from FOS, ASIC’s review of retail life insurance advice and the Royal Commission. For each, potential breaches of FASEA’s Code of Ethics will be identified.

Case study one: Establishing an SMSF with unsophisticated investors

James and Rowena are in their late 50s and sought financial advice from Jane Roundtree to prepare them for retirement. They were concerned about their financial position and had three clear financial objectives:

To reduce or eliminate their debts
To pay off their mortgage more quickly
To save for a holiday to the US to visit family

The couple’s combined income was less than $80,000 per annum, and their combined superannuation balance was $165,000. The clients’ outstanding mortgage was $205,000 on a home worth $420,000. They also had other loans and credit cards totalling $45,000.

Jane recommended that James and Rowena set up an SMSF, roll over their existing superannuation funds, and purchase units in a property trust in which Jane had a financial interest.

It should have been obvious to Jane that James and Rowena did not have the requisite financial skills to manage an SMSF for which they would be personally liable. The couple was struggling to manage their finances, had a low combined superannuation balance and no capacity to significantly increase its balance.

ASIC found the advice provided was not appropriate for James and Rowena and did not meet their needs or objectives.

Breaches of FASEA’s code of ethics

Jane advised clients to establish an SMSF in circumstances that are inappropriate. From the details provided in the case study, Jane potentially breached the following standards in FASEA’s Code of Ethics.

Case study two: Appropriateness of advice

Australian financial services licence holder ABC Financial Services Pty Ltd (ABC) was identified as providing inappropriate advice to clients regarding the establishment of SMSFs. These concerns related to:

Establishment of SMSFs with a low balance
Advice not being sufficiently tailored to the needs of each client
Inadequate comparison of clients’ existing superannuation to the recommended SMSF
Inadequate consideration of suitable alternative strategies that would have met clients’ needs
Inadequate consideration of clients’ long-term retirement planning objectives
The management of conflicts of interest where the advice provided to clients resulted in referrals to related ABC entities without adequate disclosure
ABC authorised representatives were not adequately trained and competent to provide SMSF advice.

Breaches of FASEA’s code of ethics

ABC has advised numerous clients to establish SMSFs in circumstances that are not in the best interest of clients. From the details provided in the case study, ABC’s authorised representatives potentially breached the following standards in FASEA’s Code of Ethics:

Case study three: inadequate record keeping

Richard, a 71-year-old married man consulted a financial adviser, Peter Knight, to see if he could improve his retirement income. Richard and his wife Florence owned their home and had personal investments worth $250,000. Their combined superannuation was worth $55,720, which was invested in an industry fund in a defensive option.

When he sought advice, Richard had three clear objectives. He wanted to:

Establish an income-bearing investment with the $250,000
Generate retirement income of $60,000 per year
Explore the option of setting up an SMSF to take advantage of the tax advantages he had heard about.

Peter advised Richard to roll over the existing $55,720 superannuation to set up an SMSF with an individual trustee structure. No explicit investment recommendation was made, although a capital projection was included in the SOA which showed the SMSF assets invested in a ‘balanced’ investment. Richard’s ongoing annual superannuation fund fees increased from $305 to $1,800 as a result of setting up the SMSF.

ASIC found the client file to be inadequate for a number of reasons, including:

The file notes did not demonstrate whether the client had the time, skills and knowledge to operate an SMSF.
The file notes did not refer to the client’s ability to make further contributions to superannuation. Without extra contributions, the SMSF was not economically viable.
The risk profile on file was incomplete, and there were no file notes of discussions between the client and the advice provider about decisions on investments and asset allocation.

Breaches of FASEA’s code of ethics

Peter’s advice and his notes on file were found to be inadequate by ASIC. From the details provided in the case study, Peter potentially breached the following standards in FASEA’s Code of Ethics:

Case study four: Adviser did not prioritise client interests over their own

Kerrie and Sam were aged in their late 30s, with four financially dependent children. They owned their home but had an outstanding mortgage of $380,000. Both Kerrie and Sam had retail superannuation funds with a combined balance of $195,500.

They sought financial advice and after competing the risk profiling paperwork, their adviser Bill Cunningham identified they had a ‘growth’ investor profile.

Kerrie and Sam wanted to buy a bigger home for their large family.

Bill recommended that Kerrie and Sam do the following:

Direct surplus cashflow to their existing home loan
Set up an SMSF with a corporate trustee
Roll over a majority of their superannuation into the SMSF
Make superannuation contributions into the SMSF
Purchase an investment property in the SMSF through an undisclosed related party business
Fund the property purchase using cash and borrowings that resulted in a 65% debt-to-asset ratio.

ASIC found that Bill did not prioritise the needs of his clients. Specifically:

Bill did not address the clients’ reason for seeking advice
There was no evidence on the file indicating that Kerrie and Sam wanted to establish an SMSF, or had the time and knowledge to manage it
The SMSF purchased the property through a related party real estate business, which paid a fee to Bill that was not disclosed to the clients
The strategy was high risk; there was a lack of diversification and the majority of the superannuation balance was invested in an illiquid asset with a 65% debt-to-asset ratio. This is out of step with the risk profile Bill had identified for Kerrie and Sam.

Breaches of FASEA’s code of ethics

Bill was found to have prioritised his own needs over those of his clients. From the details provided in the case study, Peter potentially breached the following standards in FASEA’s Code of Ethics:

As Australian longevity increases, the importance of retirement planning compounds. SMSFs have been a significant part of the superannuation landscape and look set to remain so. However, they are not appropriate for everyone. There’s an additional layer of factors to consider when recommending the establishment of an SMSF and as with all financial advice, it’s critical to consider what is in the client’s best interests, today and in the future.

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