CPD: Ethics and SMSFs

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SMSFs continue to be a significant part of the superannuation landscape and are likely to experience continued growth.

It was 1999 when self-managed superannuation funds (SMSFs) first became part of Australia’s superannuation landscape. Over the following twenty plus years, SMSFs have become a significant part of Australia’s $3 trillion[1] superannuation sector, with $766 billion in assets at end 2020, representing one quarter of the total super sector. Bound by an array of rules and regulations, this article, sponsored by GSFM Pty Ltd, examines the ethical considerations for advisers recommending SMSFs to clients.

In 2020, the Australian Financial Complaints Authority (AFCA) investigated a number of cases linked to SMSFs. In one of its findings AFCA noted: “For advisers to ‘know your client’, they were required to make investigations into the client’s relevant personal circumstances, including the client’s needs, circumstances, risk profile and the time frame for the investment. Where advice is for an SMSF, it is important that the adviser consider both the personal circumstances of the members of the fund and the fund itself.”

As with all forms of financial advice, the regulatory requirements that relate to providing advice to individuals is equally applicable to the investment advice provided to trustees SMSFs; after all, that advice effects both the trustees and the fund members.

This includes ASIC regulations and FASEA’s Code of Ethics, which remains unchanged despite the future changes to FASEA and its roles. ASIC’s role in relation to SMSFs is to regulate the service providers; the financial advisers, auditors, and providers of products and services to SMSFs.

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; however, the Treasury Laws Amendment (Self-Managed Superannuation Funds) Bill 2020 was introduced to the senate on 2 September 2020 to allow an increase in the maximum number of allowable members in SMSFs from four to six.

SMSFs – a growth story

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 strong growth in the sector; as illustrated in figure one, the trend has continued over the past six years, with steady 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; the main reasons for SMSF members to use financial advice were:

  1. the perceived advantages of tailored advice
  2. the perceived complexities of tax and administrative procedures
  3. to access new or inaccessible investments.

As any adviser who’s had exposure to SMSFs knows, there are many rules and regulations when it comes to SMSFs, as well as a range of costs and a few rules of thumb.

Establishing an SMSF 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 vitally 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.

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.

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).

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

  1. their fund losing its concessional tax treatment
  2. 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
  3. fines or imprisonment, depending on the seriousness of the breach.

SMSFs and financial advice

The 2020 Vanguard/Investment Trends SMSF Planner Report surveyed 3,156 SMSF trustees and 193 financial advisers. It found that one of the primary reasons underpinning the choice by Australians to run their own SMSF is control; in particular, control over ‘their own financial destiny’.

In many cases, SMSFs trustees need professional financial advice. Despite this, the number of SMSFs with unmet advice needs increased by more than 6 percent from 315,000 in 2019 to 335,000 in 2020.

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. The unmet advice needs identified in the 2020 Vanguard/Investment Trends SMSF Planner Report spanned investment strategy, retirement planning and tax planning. The first of these in particular is an area of expertise where a financial adviser can add value to trustees and their SMSF.

By way of example, it is a legal requirement for each SMSF to have a documented investment strategy, which satisfies the sole purpose test, and which is 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.

The regulatory environment

Recommending an SMSF

When giving advice to retail clients about establishing and/or switching to an SMSF, clients should be advised on the risks and costs associated with setting up and/or switching to an SMSF, the potential benefits that may be lost, the time commitment required and any other significant consequences if the advice is followed.

Further, when advising a retail client to transfer the whole or part of the balance of an existing account with a superannuation fund regulated by the Australian Prudential Regulation Authority (APRA) to an SMSF, ASIC emphasises the importance that the client should be made aware that SMSFs are not subject to the same government protections available in APRA-regulated superannuation funds, such as statutory compensation in the event of theft or fraud.

ASIC is likely to look at whether the client received advice on the lack of statutory compensation when they received a recommendation to switch their superannuation from an APRA-regulated superannuation fund to an SMSF.

When establishing an SMSF, advisers should consider and advise their client about the most appropriate SMSF structure for that client, as the structure (i.e. a corporate or individual trustee structure) can have tax and succession planning implications. It can be costly to change structures, ownership of assets and trustees once the SMSF has been established.

In the event of an investigation, ASIC will examine whether clients have been adequately advised on SMSF structures; in particular, whether the client has been directed to an SMSF without consideration of the appropriateness of the SMSF structure, or if the client has been directed to a particular type of SMSF structure without consideration of its appropriateness.

Investment strategy and Financial Advice

While the ATO may regulate SMSFs, ASIC regulates and investigates the advice you may provide to clients to establish an SMSF or in relation to an already operational SMSF.

Under superannuation laws, SMSF trustees must develop an investment strategy to ensure the SMSF is positioned to meet members’ retirement needs. Such a strategy may consider whether the SMSF members have other retirement or investment savings they can draw on and whether the SMSF’s investments are appropriately diversified.

According to ASIC, SMSF trustees should conduct a regular review of the fund’s investment strategy to ensure it remains current. It is therefore important your trustee clients understand:

  • the benefits associated with diversification across a number of asset classes in a long-term investment strategy
  • that there are some restrictions on SMSF investments, such as living in property owned by the SMSF
  • that certain transactions are prohibited, such as lending the SMSF’s money, or providing financial assistance to a member of the fund or their relatives.

In the event of an ASIC investigation, it is likely to examine the advice clients received about their SMSF investment strategy and whether or not the advice was appropriate to the risk appetite and investment goals of the client.

When providing financial advice about the investment strategy and implementation, advisers need to be aware that the relevant conduct and disclosure obligations include the best interests duty and related obligations. These require financial advisers to[3]:

  • act in the best interests of the client (section 961B)
  • provide appropriate personal advice (section 961G)
  • warn the client if advice is based on incomplete or inaccurate information (section 961H)
  • prioritise the interests of the client (section 961J).

The requirement to give retail clients an SOA when personal advice is provided (section 946A) is as relevant when the advice is given in relation to an SMSF and, if the SOA is not the means by which personal advice is provided, the SOA must be provided to the fund trustees as soon as practicable after the advice has been provided. Importantly, the SOA must be provided before the client acts on the advice (section 946C).

Ethics

As well as abiding by the relevant sections of the Corporations Act 2001 when providing advice to clients, advisers working with clients in relation to SMSFs are also obliged to comply with FASEA’s Code of Ethics. The standards of the Code must be applied at all points of the advice; from establishment of an SMSF and development of an investment strategy, through to implementation of the strategy and ongoing monitoring and management.

As will be illustrated in the following case studies, cases that have been investigated by AFCA in recent years have not only breached sections of the Corporations Act 2001, they have failed to uphold various standards in the Code of Ethics.

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 the Australian Financial Complaints Authority (AFCA) or its predecessor organisation. For each, potential breaches of FASEA’s Code of Ethics are identified.

Case study one

The complainant, John M, took his dispute to AFCA in both his personal capacity and in his capacity as sole director of the trustee company of an SMSF. The complaint is about the terms of engagement and services provided by the company SMSF Financial Advisers.

John says he was lured to SMSF Financial Advisers by promises of big returns and was advised that the only way this could be achieved was through establishing an SMSF so that he could control the investment of the superannuation funds. He was told he had to do this on a ‘no advice’ basis.

SMSF Financial Advisers says it was the complainant who, being an accounting client from a referred related practice, repeatedly sought the establishment of an SMSF, despite being advised against it because of his low super balance of approximately $35,000. The financial firm says that it eventually referred him to an SMSF specialist within its office.

AFCA found there was very little documentation to support either parties’ position. Email correspondence between SMSF Financial Advisers’ practice manager and John demonstrated the firm assisted in the establishment of the SMSF.

John produced an invoice for $5,500 for the following services:

  • establish a single member SMSF (including all ASIC & ATO fees)
  • recommendations on investments within the SMSF
  • creation of a statement of advice including strategy recommendations and outcome possibilities
  • an annual review of SMSF.

SMSF Financial Advisers said the lack of documentation was due to the fact that John was not an ‘advice’ client. It says it never made any investment recommendations, did not produce a statement of advice (SOA) or conduct an annual review. It says the invoice was generated in error and should only have included the fee in respect of establishing the SMSF. It offered to refund the balance of the invoice.

AFCA found that as SMSF Financial Advisers has professional obligations, including document retention, it would expect the firm to have recorded and retained any advice it provided to John not to establish the SMSF. It also found:

  • John’s low superannuation balance meant an SMSF was wholly unsuitable, even with the additional contributions that were said to have been proposed
  • correspondence shows the adviser was instrumental in establishing the SMSF, thereby exposing SMSF Financial Advisers to potential liability without written evidence it had warned the complainant against such a course of action
  • the invoice itself also implies the existence of a personal and ongoing advice relationship between John and the financial firm.

Accordingly, AFCA was satisfied the adviser recommended that John establish an SMSF, advice which it described as “wholly inappropriate and not in the complainant’s best interests given the low balance of the fund.”

Breaches of FASEA’s code of ethics

The adviser was found to have provided John with inappropriate advice with reference to the establishment of the SMSF. From the details provided in the case study, the adviser potentially breached the following standards in FASEA’s Code of Ethics:

Case study two

The complainants, Jenny and Kevin Smith, received advice from the adviser Paul B, to borrow and invest in property within a self-managed superannuation fund (SMSF). The dispute was made personally and also in their capacity as directors of the corporate trustee of their SMSF.

Jenny and Kevin claim they paid costly establishment fees and ongoing financial advice fees, but never received ongoing advice. They say from when they bought the property, they struggled meeting the ongoing associated expenses. They sold the property two years later.

The complainants believed the advice they received to establish the SMSF and invest in property was inappropriate and sought compensation for their loss. They wished to be reinstated to the position they would have been in, but for the advice they had received.

In assessing the complaint, AFCA assessed Jenny and Kevin’s loss against the likely outcome if they had not entered the strategy. The advice to establish an SMSF and borrow to invest in residential property was found not to be in the complainants’ best interests because it was a high cost strategy that was unlikely to leave them in a better position.

However, AFCA also ruled that Jenny and Kevin contributed to their loss by borrowing more than the adviser recommended. This contribution was assessed to be 30 percent, a factor taken into account when calculating the financial compensation awarded to the complainants.

The AFCA review found the following:

  • the adviser did not act in the clients’ best interests
  • the SOA was not clear, concise and effective
  • the costs of an SMSF and holding real property were too high to be justified.

Breaches of FASEA’s code of ethics

The SMSF advice Paul B provided to his clients was found to be deficient by AFCA. From the details provided in the case study, he potentially breached the following standards in FASEA’s Code of Ethics:

Case study three

The complainants, Judy and Mike, are individual trustees of their SMSF. This dispute lodged with AFCA was about whether their adviser, Susan K, had an obligation to review the applicants’ SMSF portfolio. The adviser was an authorised representative of the financial services provider ABC Advisers.

The complainants claimed:

  • they were provided advice that was inconsistent with their conservative risk profile
  • the shares recommended were high risk, undiversified and had a high proportion of mining or mining related companies
  • Susan K assured them that their portfolio was appropriate.

According to AFCA, the advice provided to Judy and Mike would have been appropriate if, at the time it was provided, it was fit for purpose and a reasonable adviser would have concluded that the client was likely to be in a better position if they followed the advice.

However, Judy and Mike’s SMSF portfolio had almost no diversification across asset classes and little diversification across share sectors. The portfolio was subject to concentration risk and at no time did the SMSF portfolio align with a conservative approach.

A typical conservative investor asset allocation is 70 percent exposure to defensive assets (cash, term deposits and fixed interest) and 30 percent to growth assets (shares, managed funds and property). During the relevant period, the SMSF portfolio was exposed to over 90% Australian shares, of which over 60% were in the resources sector.

Where advice is for an SMSF, it is important that the adviser consider both the personal circumstances of the members of the fund and the fund itself.

Although the trustees of the SMSF are ultimately responsible for compiling the investment strategy, where there is a misalignment between an SMSF’s risk profile and that of its members, a prudent financial adviser would advise the clients of that inconsistency. The adviser could suggest different options to resolve the conflict (e.g. altering the investment strategy of the SMSF). AFCA found no evidence that Susan did this.

Finally, Judy and Mike were paying an ongoing advice fee and, therefore, Susan had an obligation to review the applicants’ situation on at least an annual basis. Although Judy and Mike raised concerns about the concentration of mining shares in their SMSF portfolio, Susan did not address their concerns or look to de-risk their portfolio to align with their conservative risk profile.

As a result, AFCA found the following:

  • Susan had an obligation to review the portfolio and to reconcile the investment strategy with the applicants’ risk profiles
  • she failed to provide any review or advice and therefore did not act in the best interests of the SMSF
  • adviser inaction caused the SMSF to suffer a loss of $198,886.03, which had to be repaid plus interest.

AFCA also found that the licensee was responsible for the inaction of the adviser.

Breaches of FASEA’s code of ethics

Susan K provided poor advice with respect to Judy and Mike’s SMSF. From the details provided in the case study, she potentially breached the following standards in FASEA’s Code of Ethics:

As the longevity of Australia’s population increases, the importance of retirement planning compounds. SMSFs continue to be a significant part of the superannuation landscape and are likely to experience continued growth in terms of the numbers of funds established and assets under management within funds.

Importantly, SMSFs are not appropriate for everyone. There’s a range of factors to consider when recommending the establishment of an SMSF, as well as an appropriate investment strategy; 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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[1] APRA superannuation statistics, 31 December 2020
[2] Report 576 Member experiences with self-managed superannuation funds
[3] ASIC Information Sheet 205

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